Floating rate bond

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What Is a Floating Rate Bond?

A floating rate bond (FRB) is a debt instrument with a variable coupon rate that adjusts periodically based on a benchmark interest rate plus a specified spread. Unlike a fixed-rate bond, whose interest payments remain constant throughout its life, a floating rate bond's payments fluctuate with market conditions. This characteristic places floating rate bonds within the broader financial category of fixed income securities, appealing to investors seeking to manage the impact of changing interest rates. The variable nature of the floating rate bond's coupon aims to keep its market price closer to its principal value, as its yield automatically adjusts to prevailing rates.

History and Origin

Floating rate notes originated in Europe and were first introduced in the United States in 1974. Citicorp issued a notable 15-year floating rate note for $650 million that year.³² Early floating rate bonds often referenced the London Interbank Offered Rate (LIBOR).³¹ However, concerns about LIBOR's reliability and susceptibility to manipulation, which became apparent after the 2008 global financial crisis, led global regulators to initiate a transition to more robust alternative reference rates.³⁰,²⁹

In the United States, the Secured Overnight Financing Rate (SOFR) emerged as the preferred alternative to U.S. dollar LIBOR.²⁸,²⁷ The Alternative Reference Rates Committee (ARRC), convened by the Federal Reserve, recommended SOFR in 2017.²⁶,²⁵ SOFR measures the cost of overnight borrowings collateralized by U.S. Treasury securities, based on a significant volume of daily transactions.²⁴,²³,²² The formal cessation of all U.S. dollar LIBOR panel settings occurred on June 30, 2023, marking a major step in this transition.²¹,²⁰

The U.S. Treasury Department itself began issuing Floating Rate Notes (FRNs) in January 2014, marking the first new marketable security since Treasury Inflation-Protected Securities (TIPS) were introduced in 1997.¹⁹,¹⁸,¹⁷ These Treasury FRNs are typically short-term investments, maturing in two years, and pay interest quarterly. Their interest rate is tied to the most recent 13-week Treasury bill auction rate plus a fixed spread determined at issuance.¹⁶,¹⁵,¹⁴

Key Takeaways

• A floating rate bond's coupon rate adjusts periodically based on a benchmark interest rate and a fixed spread.
• FRBs offer a hedge against rising interest rates, as their interest payments increase with the benchmark rate.
• They tend to exhibit greater price stability compared to fixed-rate bonds, especially in volatile interest rate environments.
• The Secured Overnight Financing Rate (SOFR) has largely replaced LIBOR as the primary reference rate for floating rate bonds.
• While mitigating interest rate risk, floating rate bonds may carry other risks such as credit risk and liquidity risk.

Formula and Calculation

The interest rate for a floating rate bond is generally calculated as:

Where:

• Reference Rate: A widely accepted money market benchmark, such as SOFR or the 13-week Treasury bill rate. This rate resets periodically (e.g., daily, weekly, or quarterly).
• Spread: A fixed percentage added to the reference rate, determined at the time the floating rate bond is issued. This component remains constant over the life of the bond.

For example, if the reference rate is the 3-month SOFR and the spread is 0.20%, a typical floating rate bond coupon might be expressed as 3-month USD SOFR + 0.20%.

Interpreting the Floating Rate Bond

Interpreting a floating rate bond primarily involves understanding how its variable coupon aligns with market expectations and investor objectives. The key feature of a floating rate bond is its ability to adjust its yield in response to changes in the underlying reference rate. This characteristic makes them particularly attractive in periods of rising interest rate environments, as the bond's interest payments will increase, helping to preserve the purchasing power of the income stream.

Conversely, in a falling interest rate environment, the coupon payments of a floating rate bond will decrease, potentially leading to lower income for the bondholder. While the bond's price tends to be more stable than that of a fixed-rate bond due to its self-adjusting coupon, the income stream is variable. Investors evaluate floating rate bonds by considering the current reference rate, the spread offered, the frequency of coupon resets, and the creditworthiness of the issuer. A higher spread typically indicates higher perceived credit risk or a greater incentive offered by the issuer.

Hypothetical Example

Consider an investor purchasing a newly issued $1,000 par value floating rate bond with a two-year maturity. The bond's coupon rate is set to reset quarterly based on the 3-month SOFR plus a fixed spread of 0.50% (50 basis points).

• Quarter 1: The 3-month SOFR is 4.00%.

  • The coupon rate for this quarter is 4.00% + 0.50% = 4.50%.
  • Quarterly interest payment: $1,000 * (4.50% / 4) = $11.25.

• Quarter 2: The 3-month SOFR rises to 4.75%.

  • The coupon rate for this quarter is 4.75% + 0.50% = 5.25%.
  • Quarterly interest payment: $1,000 * (5.25% / 4) = $13.125.

• Quarter 3: The 3-month SOFR falls to 4.25%.

  • The coupon rate for this quarter is 4.25% + 0.50% = 4.75%.
  • Quarterly interest payment: $1,000 * (4.75% / 4) = $11.875.

This example illustrates how the interest payments from the floating rate bond adjust with changes in the underlying SOFR, providing varying income to the investor.

Practical Applications

Floating rate bonds are employed by both issuers and investors for various purposes within the financial markets. For investors, particularly in a rising interest rate environment, floating rate bonds can offer a compelling alternative to traditional fixed-rate bond investments. Their variable coupon mechanism helps to mitigate interest rate risk, as the yield adjusts to prevailing market rates, leading to greater price stability than fixed-rate counterparts.¹³ This makes them attractive for investors seeking to preserve capital while still generating income.¹² Exchange-Traded Funds (ETFs) that invest in floating rate notes, such as the iShares Floating Rate Note ETF (FLOT) or the WisdomTree Floating Rate Treasury Fund (USFR), provide an accessible way for individual investors to gain exposure to these securities and manage duration concerns.¹¹,¹⁰

Issuers, including corporations, financial institutions, and governments, utilize floating rate bonds to manage their borrowing costs. For example, the U.S. Treasury issues Floating Rate Notes as part of its debt management strategy, aiming to diversify its funding sources and potentially reduce long-term interest expenses.⁹,⁸,⁷ Banks and other financial service companies are among the largest corporate issuers of these securities. In India, the government has also been active in issuing floating rate bonds through scheduled auctions.⁶ While floating rate bonds can offer benefits in managing interest rate exposures, some market participants believe that the market for these bonds, especially for individual investors, is largely synonymous with bank loan funds, which can carry higher credit risk.⁵

Limitations and Criticisms

Despite their advantages, floating rate bonds have certain limitations and criticisms. One primary concern is that while they reduce interest rate risk for the investor, they expose the investor to greater credit risk, especially if the issuers are non-investment grade.⁴ The market for floating rate bonds, particularly for those issued by corporations, can also be vulnerable to "shocks," presenting a liquidity risk.³

Furthermore, the price stability often attributed to floating rate bonds may not always materialize as expected. During periods of extreme interest rate volatility, the coupon rates may not reset quickly enough to prevent price fluctuations. Also, the coupon rates of floating rate bonds are often lower than those of long-term fixed-rate bonds and may not be particularly attractive compared to shorter-maturity bonds. While floating rate bonds offer yield preservation in rising rate environments, they may underperform fixed-rate bonds when interest rates are falling, as their yields will decline accordingly.² This means that while they protect against rising rates, they do not offer the same potential for capital appreciation that fixed-rate bonds might experience when rates decline.¹

Floating Rate Bond vs. Fixed-Rate Bond

The primary distinction between a floating rate bond and a fixed-rate bond lies in how their coupon rate is determined. A fixed-rate bond pays a predetermined interest rate that remains constant throughout the bond's life, providing a predictable stream of income. In contrast, a floating rate bond's coupon rate adjusts periodically based on a benchmark interest rate plus a fixed spread.

This fundamental difference leads to varying exposures to interest rate risk. Fixed-rate bonds are highly sensitive to changes in market interest rates; when rates rise, the market value of existing fixed-rate bonds with lower coupons typically falls, and vice versa. Floating rate bonds, by periodically resetting their coupon, tend to maintain their market price closer to their par value, making them less sensitive to interest rate fluctuations. However, this also means that floating rate bonds will not experience the capital appreciation seen in fixed-rate bonds when interest rates decline.

FAQs

What is the main advantage of a floating rate bond?

The main advantage of a floating rate bond is its ability to adjust its interest payments in line with current market interest rates. This feature helps protect investors from the negative impact of rising interest rates on a bond's price and income stream, offering a hedge against interest rate risk.

How often do floating rate bond coupons reset?

The reset frequency for floating rate bond coupons can vary, but most commonly, they reset quarterly. Some may reset weekly or daily, depending on the specific terms of the bond and the underlying reference rate.

Are floating rate bonds suitable for all investors?

Floating rate bonds can be suitable for investors who anticipate rising interest rates or wish to reduce their exposure to interest rate risk. However, they may not be ideal for investors seeking predictable income streams or those who believe interest rates will fall, as the income generated will fluctuate and could decrease. Investors should also consider the issuer's credit risk.