What Is an Inverse Floater?
An inverse floater is a bond or other type of debt whose coupon rate has an inverse relationship to a benchmark rate. An inverse floater adjusts its coupon payment as the interest rate changes. An inverse floater is also known as an inverse floating rate note or a reverse floater.
Governments and corporations are the typical issuers of these bonds, which they sell to investors in order to raise funds. Governments might use these funds to build roads and bridges, while corporations might use the funds from a bond sale to build a new factory or buy equipment. Investors of an inverse floater will receive cash payments in the form of periodic interest payments, which will adjust in the opposite direction of the prevailing interest rate.
- An inverse floater is a bond or other type of debt instrument that has a coupon rate that varies inversely with a benchmark interest rate.
- Investors who purchase inverse floaters will receive interest payments that are adjusted according to changes in the current interest rates.
- For an inverse floater, the interest rates the investor receives will adjust in the opposite direction of the prevailing rates; thus, when interest rates fall, the rate of the bond's payments increases.
- Investors of inverse floaters face interest rate risk, which is the potential for investment losses due to changes in interest rates.
How an Inverse Floater Works
An inverse floating rate note, or inverse floater, works in the opposite way of a floating-rate note (FRN), which is a fixed income security that makes coupon payments that are tied to a reference rate. The coupon payments for a floating-rate note are adjusted following changes in the prevailing interest rates in the economy. When interest rates rise, the value of the coupon increases to reflect the higher rate.
Floating-rate notes might use the London Interbank Offered Rate (LIBOR), Euro Interbank Offer Rate (EURIBOR), the prime rate, or the U.S. Treasury rate for their reference or benchmark interest rates.
For an inverse floater, the coupon rate on the note varies inversely with the benchmark interest rate. Inverse floaters come about through the separation of fixed-rate bonds into two classes: a floater, which moves directly with some interest rate index, and an inverse floater, which represents the residual interest of the fixed-rate bond, net of the floating-rate.
An inverse floater has a fluctuating interest rate; this differs from a fixed-rate note, which pays the same interest rate throughout the life of the note.
Calculating an Inverse Floater
To calculate the coupon rate of an inverse floater, you will need to subtract the reference interest rate from a constant on every coupon date. When the reference rate goes up, the coupon rate will go down given that the rate is deducted from the coupon payment. A higher interest rate means more is deducted, and the noteholder will be paid less. Similarly, as interest rates fall, the coupon rate increases because less is subtracted.
The general formula for the coupon rate of an inverse floater can be expressed as:
Floating rate = Fixed rate – (Coupon leverage x Reference rate)
The coupon leverage is the multiple by which the coupon rate will change for a 100 basis point (bps) change in the reference rate. The fixed-rate is the maximum rate the floater can realize.
Example of an Inverse Floater
A typical inverse floater might have a maturity date in three years, pay interest quarterly, and include a floating rate of 7% minus two times the 3-month LIBOR. In this case, when LIBOR goes up, the rate of the bond’s payments goes down. To prevent a situation whereby the coupon rate on the inverse floater falls below zero, a restriction or floor is placed on the coupons after adjustment. Typically, the floor is set at zero.
Benefits of an Inverse Floater
An investor would want to invest in an inverse floater if the benchmark rate is high and they believe the rate will decrease in the future at a faster rate than the forward contracts indicate. Another strategy is to buy an interest rate floater if the rates are low now and it is expected that they stay low, even though the forward contracts are implying an increase. If the investor is correct and the rates do not change, the investor will outperform the floating rate note by holding the inverse floater.
As with all investments that employ leverage, inverse floaters introduce a significant amount of interest rate risk. When short-term interest rates fall, both the market price and the yield of the inverse floater increases, magnifying the fluctuation in the bond's price.
On the other hand, when short-term interest rates rise, the value of the bond can drop significantly, and holders of this type of instrument may end up with a security that pays little interest. Thus, interest rate risk is magnified and contains a high degree of volatility.