DEFINITION of Reverse Floater

A reverse floater is a floating-rate note in which the coupon rises when the underlying reference rate falls. The underlying reference rate is often the London Interbank Offered Rate (LIBOR), the rate at which banks can borrow funds from other banks in the London interbank market, the most common benchmark for short-term interest rates.

A reverse floater is also known as a reverse floating-rate debt or an inverse floater.

BREAKING DOWN Reverse Floater

A floater is a fixed income security that makes coupon payments that are tied to a short-term reference rate. The coupon payments are adjusted following changes in the prevailing interest rates in the economy. When interest rates rise, the value of the coupons is increased to reflect the higher rate. Possible reference or benchmark rates include the London Interbank Offer Rate (LIBOR), Euro Interbank Offer Rate (EURIBOR), federal funds rate, US Treasury rates, etc.

A reverse floater is a type of floater in which the coupon rate varies inversely with the reference interest rate. Reverse floaters are formed through the separation of fixed rate bonds into two classes: (1) a floater, which moves directly with some interest rate index, and (2) an inverse floater, which represents the residual interest of the fixed-rate bond, net of the floating-rate. The coupon rate is calculated by subtracting 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. For example, the coupon on a reverse floater may be calculated as 10% minus 3-mth LIBOR. A higher reference rate would mean more will be deducted from the constant and, thus, less will be paid to the debtholder. Similarly, as interest rates fall, the coupon rate increases because less is subtracted from the constant.

The floating rate resets with each coupon payment and may have a cap and/or floor. 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. In a case in which the floor is zero and the 3-mth LIBOR is greater than the constant rate, the coupon rate will be set at zero as it cannot be negative.

Reverse floaters offer guaranteed principal and are an option for investors looking to benefit from falling interest rates. 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.