What Is Floating Rate Bonds?
Floating rate bonds, often referred to as variable-rate bonds, are a type of fixed income security where the coupon rate is not fixed but instead adjusts periodically based on a predetermined benchmark rate. This adjustment typically occurs every month, quarter, or semi-annually. The primary appeal of floating rate bonds lies in their ability to offer investors a defense against rising interest rates, as the income stream they provide increases with the benchmark. As instruments within the broader bond market, floating rate bonds stand apart due to their dynamic interest payments.
History and Origin
While various forms of variable interest rate debt have existed, the modern concept of floating rate bonds gained significant traction as financial markets evolved and sought mechanisms to manage interest rate risk. In the United States, a notable development was the introduction of Treasury Floating Rate Notes (FRNs) by the U.S. Department of the Treasury. These notes, which began trading in January 2014, offered investors a new option for very safe, short-duration investments with coupons that adjust with the 13-week Treasury bill rate. FRNs are purchased through the TreasuryDirect website, providing direct access to this type of government debt.8 This marked a significant official endorsement and standardization of floating rate bonds for broader public investment.
Key Takeaways
- Floating rate bonds pay interest that adjusts periodically based on a benchmark rate plus a fixed spread.
- They offer protection against rising interest rates, as their coupon payments increase when the benchmark rate rises.
- The price volatility of floating rate bonds due to interest rate changes is generally lower compared to fixed-rate bonds.
- They carry credit risk, similar to other bonds, as the issuer's ability to pay interest and principal is always a factor.
- Floating rate bonds can be found in various forms, including corporate, government, and municipal debt.
Formula and Calculation
The interest payment for a floating rate bond is typically calculated by adding a specified spread to a chosen benchmark rate. The spread remains constant over the life of the bond, while the benchmark rate fluctuates.
The formula for the coupon rate ((C)) at any given reset period is:
[
C = \text{Benchmark Rate} + \text{Spread}
]
Where:
- Benchmark Rate: A variable interest rate, such as the Secured Overnight Financing Rate (SOFR), which replaced LIBOR in many contexts. Information about SOFR, for instance, can be found from the Federal Reserve Bank of New York.7
- Spread: A fixed percentage added to the benchmark rate, determined at the time of issuance, reflecting the issuers' creditworthiness and market conditions.
For example, if the benchmark rate is SOFR and the spread is 0.50%, the coupon rate for that period would be SOFR + 0.50%. The bond's yield will thus change with the benchmark.
Interpreting the Floating Rate Bonds
Understanding floating rate bonds involves recognizing their sensitivity to interest rate movements and the implications for a portfolio. When benchmark rates rise, the coupon payments from floating rate bonds increase, providing a higher income stream to the bondholder. This characteristic makes them particularly attractive in periods of expected or actual rising interest rates, as they help mitigate the negative impact that higher rates typically have on the market value of fixed-rate securities. Conversely, when benchmark rates fall, the income generated by floating rate bonds will decrease. While their market price is less sensitive to interest rate fluctuations compared to fixed-rate bonds (due to their low duration), their income stream directly reflects the prevailing interest rate environment. Investors interpret these bonds as a way to maintain purchasing power during inflationary periods when interest rates tend to rise.6
Hypothetical Example
Consider an investor who purchases a floating rate bond with a face value of $1,000. The bond's coupon rate is set at the 3-month SOFR plus a spread of 1.50%. The interest payments are reset quarterly.
In the first quarter, if the 3-month SOFR is 4.00%, the coupon rate for that quarter will be 4.00% + 1.50% = 5.50%. The annual interest payment would be $55 ($1,000 * 5.50%), paid quarterly, meaning $13.75 per quarter.
In the second quarter, suppose the 3-month SOFR increases to 4.75%. The new coupon rate for this quarter automatically adjusts to 4.75% + 1.50% = 6.25%. The annual interest payment will now be $62.50, or $15.63 per quarter, reflecting the higher prevailing interest rates. This automatic adjustment distinguishes floating rate bonds from traditional debt instruments.
Practical Applications
Floating rate bonds are employed by both issuers and investors for specific strategic purposes. For investors, they are often used as a hedge against inflation and rising interest rates. In environments where the Federal Reserve is raising rates, floating rate bond funds, often referred to as bank loan funds, have demonstrated resilience.5 These funds invest in senior secured bank loans, which typically have floating rates. From the issuer's perspective, floating rate bonds can be attractive because they allow them to tap into market demand for variable-rate instruments and manage their own interest rate exposure. Companies might issue floating rate debt if they anticipate a decline in future interest rates or if they want to match the funding costs of their floating-rate assets. The Investment Company Institute (ICI) has also highlighted the significance of bank loan funds, which invest primarily in floating-rate loans, in facilitating corporate financing, even noting that the Securities and Exchange Commission (SEC) has considered rules that could impact their structure.4
Limitations and Criticisms
Despite their advantages, floating rate bonds are not without limitations and criticisms. One significant concern is their inherent credit risk. While their interest rate risk is low due to the floating coupon, the underlying credit quality of the issuers remains paramount. If the issuer's financial health deteriorates, there is a risk of default, irrespective of interest rate movements. Critics argue that in a flight to safety during economic downturns, these bonds, particularly those issued by corporations, may not provide the same shelter as high-quality, short-term fixed income instruments or money market accounts.3 For example, during the 2008 financial crisis, some floating-rate funds experienced significant losses, reflecting the credit-sensitive nature of their underlying assets.2 Furthermore, while the coupon adjusts, the principal value can still be affected by changes in credit spreads or liquidity in the market.
Floating Rate Bonds vs. Fixed-Rate Bonds
The key distinction between floating rate bonds and fixed-rate bonds lies in how their interest payments are determined.
| Feature | Floating Rate Bonds | Fixed-Rate Bonds |
|---|---|---|
| Coupon Rate | Adjusts periodically based on a benchmark plus a spread | Remains constant over the bond's life |
| Interest Rate Risk | Generally low, as price is less sensitive to rate changes | High, as price moves inversely to interest rates |
| Income Stream | Variable, increases with rising rates, decreases with falling rates | Predictable, fixed income stream |
| Inflation Hedge | Offers some protection against rising inflation and interest rates | Vulnerable to inflation, as purchasing power of fixed payments declines |
| Market Value Stability | More stable in changing interest rate environments | More volatile in changing interest rate environments |
While floating rate bonds provide an adaptive income stream, fixed-rate bonds offer predictability and are often preferred by investors seeking a stable cash flow, especially in declining interest rate environments. The choice between the two often depends on an investor's outlook on interest rates and their tolerance for income variability versus price volatility. Floating rate bonds are often considered higher in an issuer's capital structure compared to some other forms of debt, particularly in the case of bank loans.1
FAQs
How do floating rate bonds protect against inflation?
Floating rate bonds offer protection against inflation because their interest payments increase when the underlying benchmark rate rises, which often happens in response to inflationary pressures. This allows the bond's income stream to keep pace with, or at least partially offset, the eroding effect of inflation on purchasing power.
Are floating rate bonds risk-free?
No, floating rate bonds are not risk-free. While they have lower interest rates risk compared to fixed-rate bonds, they still carry credit risk, meaning the risk that the issuer may default on interest or principal payments. Their market value can also be affected by liquidity and credit spread changes.
Who typically invests in floating rate bonds?
Institutional investors such as banks, mutual funds, and pension funds often invest in floating rate bonds, particularly those that need to manage interest rate exposure or match liabilities. Individual investors can also gain exposure through floating rate bond funds or exchange-traded funds (ETFs). These securities are appealing to those who anticipate rising interest rates and seek to mitigate the negative impact on their portfolio.