A floating-rate security, also known as a “floater”, is an investment with interest payments that float or adjust periodically based upon a predetermined benchmark. While floaters may be linked to almost any benchmark and pay interest based on a variety of formulas, the most basic type pays a coupon equal to some widely followed interest rate (benchmark rate) such as LIBOR, plus a fixed spread in basis points (1bp = 1/100 of 1% or 0.01%).
Who Invests in Floaters
Investors who believe that interest rates and/or inflation may rise and are dissatisfied with low short-term rates may consider a floating-rate investment.
Who Issues Floaters
Government, Government-Sponsored Enterprises (GSEs), and Corporations issue floaters as part of their overall funding strategy.
How are Floaters Structured
Apart from the credit-worthiness from the issuer, the important determinant of a floater’s performance is the underlying benchmark or the reference rate, such as year over year change in the CPI (Consumer Price Index). An example of this coupon structure might read Monthly reset, % change in CPI + 150bp. Other floating rate securities are based on the 3-month London Interbank Offer Rate (3-month LIBOR). An example of spread for this security might read Quarterly Reset, 3-month LIBOR +100bp. Reference rates typically used as benchmarks include U.S. Treasury Bills (T-bills), the London Interbank Offered Rate (LIBOR), the Prime Rate, another short-term interest rate, or CPI (Consumer Price Index). Once the benchmark is chosen, the issuer will establish an additional “spread” that it is willing to pay in excess of the reference rate. This spread is generally expressed in basis points (a basis point is one one-hundredth of one percent or 0.01%) and is added to the reference rate to determine the overall coupon. For example, a floater may be issued with a spread of 40 basis points above the three-month T-bill rate. If the T-bill rate is 2.00% on the day the floater is issued, its initial coupon will be 2.40% (2.00% + 0.40% = 2.40%). The spread for any particular floater will be based on a variety of factors including the credit quality of the issuer and the time to maturity. It is important to note that since short-term rates are usually lower than long-term rates, the initial coupon of a floater is typically lower than that of a fixed-rate note of the same maturity.
Other floating rate securities are based on the 3-month London Interbank Offer Rate (3-month LIBOR). Another important component of a floater’s structure is the reset frequency — how often the interest rate is adjusted to reflect the current reference rate. A floater’s coupon can reset as often as daily or as infrequently as once per year. It is common for the coupon to reset each time an interest payment is made, and then remain constant until the next coupon payment date. If the floater resets more frequently than interest is paid, the coupon payment will reflect the average of each reset since the previous interest payment. For example, a monthly reset/quarterly pay floater’s interest payment would reflect the average of the three monthly resets that occurred in the previous quarter.
A floater may be issued as either non-callable or callable. If issued as callable, the call is at the option of the issuer, giving the issuer an opportunity to pay the principal to the holders and stop making payments. Floaters have a variety of maturities, although most are issued with maturities of 10 years or less.
Understanding Caps and Floors
Many floaters are issued with a “cap”, a “floor,” or both. A cap is the maximum interest rate the issuer will pay regardless of how high the reference rate may go and therefore protects the issuer from escalating interest costs. Conversely, a floor sets the minimum rate that will be paid even if the coupon determined by the reference rate were lower, and protects the investor from declining income. The following table illustrates the difference between two floaters that pay a spread of 40 basis points above the reference rate; one with a 4% cap and 2% floor, and one without a cap or floor:
Ref. Rate With Cap/Floor No Cap/Floor
|Coupon Rate with Cap/Floor
|Coupon Rate without Cap/Floor
Benefits of Investing in Floaters
Benefit from Rising Interest Rates
Investors are sometimes reluctant to “lock-in” a current fixed rate for the long term because they believe rates will rise. However, rates available on short-term investments may be lower than the investor is willing to accept. Floaters offer an alternative that pays a spread above current short-term rates and also enjoys the benefit of future rate increases.
Limited Price Sensitivity to Interest Rates
Fixed-rate bonds tend to decrease in value when interest rates rise and increase in value when rates fall. The bond’s value changes to compensate for the difference between its fixed coupon rate and current interest rates. Because a floater’s coupon rate changes when market rates change, its price will normally fluctuate less than fixed-rate bonds of similar maturity. However, there is no assurance that coupon changes will reflect the current level of interest rates.
Floaters are most suitable for purchasing and holding to maturity. However, investors may find it necessary to sell their floating-rate investment prior to maturity. Floaters may be traded in the secondary market, which provides an opportunity for investors to sell them at then prevailing market levels, which may be more or less than the purchase price. Although not obligated to do so, Raymond James and other broker/dealers may maintain a secondary market in floating rate securities. However, there is no assurance that an active market will develop or be maintained.
Reference Rate Risk
While the market value of a floater under normal circumstances is relatively insensitive to changes in interest rates, the income received is highly dependent upon the level of the reference rate over the life of the investment. Total return may be less than anticipated if future interest rate or reference rate expectations are not met.
As with any fixed-income investment, there is a risk that the issuer will be unable to meet its payment obligations. Changes in the creditworthiness of the issuer (whether reflected in changes to the issuer’s rating) can decrease or increase the current market value and may result in a partial or total loss of your investment. Securities ratings provided by independent nationally recognized statistical organizations, also called Rating Agencies, are appraisals of the financial stability of a particular issuer and its ability to pay income and return the principal on your investment. Although they can assist investors in evaluating the creditworthiness of an issuer, ratings are not recommendations to buy, sell, or hold a security nor do ratings remove market risk. In addition, ratings are subject to review, revision, suspension, reduction, or withdrawal, and any of these changes in ratings may affect the current market value of your investment.
If a callable floater is called by the issuer prior to maturity, the investor may be unable to reinvest funds in another floater with comparable terms. If the floater is not called, the investor should be prepared to hold it until maturity.
There are many other risks involved. Interested participants can join our CFA Institute Investment Foundations Certificate Program, CFA, or FRM classes.