Floating rate liabilities

What Is Floating Rate Liabilities?

Floating rate liabilities represent financial obligations where the interest rate paid on the borrowed principal changes periodically over the life of the debt. Unlike fixed-rate debt, which maintains a constant interest rate throughout its term, floating rate liabilities adjust based on a predetermined benchmark rate plus a specified spread or margin. This dynamic interest payment structure is a core component of modern debt financing and falls under the broader category of corporate finance and debt management.

These liabilities are prevalent in various financial instruments, including adjustable-rate mortgages, corporate loans, and certain types of bonds. The variable nature of floating rate liabilities means that the cost of borrowing can increase or decrease over time, directly impacting the borrower's cash flow and financial planning.

History and Origin

The concept of floating interest rates emerged as a response to periods of high inflation and volatile interest rates, which made long-term, fixed-rate commitments less appealing for lenders. Floating rate notes (FRNs), a type of floating rate liability, first appeared in the United States in 1974 with a significant issuance by Citicorp. These early FRNs often included a "put" feature, allowing holders to redeem notes at their discretion after a certain period, which provided some flexibility in an uncertain rate environment.¹⁷

Initially, the London Interbank Offered Rate (LIBOR) became a dominant benchmark rate for various floating rate instruments globally, influencing trillions of dollars in contracts.¹⁶ LIBOR was established in the 1960s and formally administered by the British Bankers Association from 1986, based on submissions from major banks regarding interbank lending rates.¹⁵ However, following the 2008 global financial crisis and subsequent manipulation scandals, LIBOR's integrity was questioned, leading to a coordinated international effort to transition away from it.¹⁴ Regulators encouraged the adoption of more robust, transaction-based "risk-free rates" (RFRs).¹³ The Alternative Reference Rates Committee (ARRC), convened by the Federal Reserve, selected the Secured Overnight Financing Rate (SOFR) in 2017 as the preferred alternative to U.S. dollar LIBOR.¹² The final major step in the transition, the cessation of all U.S. dollar LIBOR panel settings, occurred on June 30, 2023, with SOFR now being the dominant U.S. dollar interest rate benchmark.¹¹

Key Takeaways

• Floating rate liabilities have an interest rate that adjusts periodically based on a benchmark rate plus a spread.
• They are common in loans, mortgages, and bonds, exposing borrowers to changing interest costs.
• The primary benchmark for U.S. dollar floating rate liabilities has largely transitioned from LIBOR to SOFR.
• Borrowers benefit from falling interest rates but face increased costs if rates rise.
• Lenders benefit from rising rates but earn less if rates decline.

Formula and Calculation

The interest payment for a floating rate liability is typically calculated using a simple formula:

$\text{Interest Rate} = \text{Benchmark Rate} + \text{Spread}$

For example, if a loan is priced at SOFR + 200 basis points (2%), and the current SOFR is 5%, the interest rate applied would be 7%. This rate is then used to calculate the interest payment for the period based on the outstanding principal. The benchmark rate resets at specified intervals, such as monthly, quarterly, or semi-annually, leading to changes in the overall interest rate and subsequent payments. The spread generally remains constant over the life of the obligation and reflects the borrower's credit risk and market conditions at the time of issuance.

Interpreting Floating Rate Liabilities

Interpreting floating rate liabilities involves understanding the relationship between the benchmark rate, the spread, and their potential impact on financial obligations. For borrowers, a floating rate liability means their future interest expenses are uncertain. When general interest rates in the economy rise, the cost of servicing floating rate liabilities also increases. Conversely, if interest rates fall, the borrower's payments will decrease, potentially saving them money.

The spread above the benchmark often reflects the perceived credit risk of the borrower; a higher spread typically indicates a higher risk profile. For instance, a company with a strong financial standing might secure a loan at SOFR + 1.5%, while a riskier borrower might pay SOFR + 4%. The direction and volatility of the yield curve can also influence the attractiveness and cost of floating rate debt compared to fixed-rate alternatives.

Hypothetical Example

Consider a small manufacturing company, "Apex Innovations," which secures a $10 million, five-year syndicated loan to expand its production capacity. The loan is structured as a floating rate liability, with interest payments resetting quarterly based on SOFR + 300 basis points (3%).

• Quarter 1: SOFR is 4%. Apex's interest rate is 4% + 3% = 7%.
• Quarter 2: The Federal Reserve raises interest rates, and SOFR increases to 4.5%. Apex's new interest rate is 4.5% + 3% = 7.5%.
• Quarter 3: Economic slowdown leads to a decrease in SOFR to 3.8%. Apex's new interest rate is 3.8% + 3% = 6.8%.

This example illustrates how Apex Innovation's interest expenses fluctuate each quarter, directly tied to changes in the underlying SOFR benchmark rate. The company benefits from the rate decrease in Quarter 3 but faces higher costs when SOFR rises.

Practical Applications

Floating rate liabilities are widely utilized across various sectors of the economy for diverse purposes:

• Corporate Finance: Many companies use floating-rate loans to finance operations, particularly when anticipating rising interest rates or when the short-term cost of borrowing is lower than long-term fixed rates. These loans are often packaged into collateralized loan obligations (CLOs) and sold to investors.¹⁰
• Mortgages: Adjustable-rate mortgages (ARMs) are common examples of floating rate liabilities for consumers, where the interest rate adjusts periodically after an initial fixed-rate period.
• Government Debt: While often associated with fixed-rate Treasury bonds, governments can also issue floating rate notes. The cost of financing U.S. government debt is significantly affected by changing interest rates, especially with a large share of shorter-term securities that roll over frequently.⁹ The Federal Reserve's monetary policy, which influences benchmark rates like the federal funds rate, directly impacts the borrowing costs of various floating rate liabilities for both consumers and corporations.⁸
• Financial Institutions: Banks and other financial institutions often use floating rate liabilities to fund their assets, particularly those with variable rates themselves, like loans. This helps manage interest rate risk by matching the interest rate sensitivity of their assets and liabilities.

Limitations and Criticisms

Despite their flexibility, floating rate liabilities come with inherent limitations and criticisms, primarily centered on interest rate risk.

• Interest Rate Volatility for Borrowers: The most significant drawback for borrowers is the uncertainty of future interest payments. If benchmark rates rise sharply, the cost of servicing the debt can become prohibitive, potentially leading to financial strain or even default.⁷ While some floating rate loans might include features like interest rate caps, these limit potential upside for lenders and are not always available.⁶
• Credit Risk for Investors: For investors in floating rate notes or funds that hold these liabilities, while they offer protection against rising rates, they are not risk-free. Many floating-rate loans, particularly in the leveraged loan market, are made to companies with higher levels of debt and below investment-grade credit quality, carrying greater credit risk than high-quality bonds.⁵,⁴ In an economic downturn or recession, these companies may struggle financially, increasing the likelihood of default, which can significantly impact investor returns.³
• Budgeting Difficulty: The unpredictability of interest rate changes makes financial planning and budgeting more challenging for borrowers with floating rate liabilities.²
• Complexity: Some floating rate instruments, especially those with complex structures or embedded options like caps and floors, can be difficult for non-expert investors to fully understand and evaluate.

Floating Rate Liabilities vs. Fixed Rate Liabilities

The primary distinction between floating rate liabilities and fixed-rate debt lies in the nature of their interest rate. Floating rate liabilities feature a variable interest rate that adjusts over time, typically tied to a specified benchmark, exposing the borrower to interest rate risk. This means payments can increase or decrease, impacting cash flow.

In contrast, fixed-rate liabilities maintain a constant interest rate for the entire duration of the debt. This predictability provides stability in budgeting and cash flow forecasting for the borrower, as payments remain unchanged regardless of market interest rate fluctuations. However, fixed-rate borrowers miss out on potential savings if interest rates decline, a benefit that accrues to those with floating rate liabilities. The choice between the two often depends on the prevailing interest rate environment, the borrower's risk tolerance, and their outlook on future interest rate movements.

FAQs

What causes floating interest rates to change?

Floating interest rates change primarily due to movements in the underlying benchmark rate they are tied to, such as SOFR or the Prime Rate. These benchmark rates are influenced by overall economic conditions, inflation expectations, and central bank monetary policy, particularly decisions made by the Federal Reserve regarding the federal funds rate.

Are floating rate liabilities always cheaper than fixed rate liabilities?

Not necessarily. While floating rates may initially be lower than comparable fixed rates, particularly in a positive yield curve environment, they can become more expensive if interest rates rise significantly. The overall cost depends on the path of interest rates over the life of the liability.

Do floating rate liabilities protect against inflation?

For borrowers, floating rate liabilities do not directly protect against inflation; in fact, rising inflation often leads to higher interest rates, increasing the cost of floating rate debt. For investors holding floating rate instruments, they can offer a hedge against inflation because their interest payments increase as rates rise, helping to preserve the purchasing power of their income.¹

Who typically uses floating rate liabilities?

Both individuals and corporations use floating rate liabilities. Individuals might encounter them through adjustable-rate mortgages or certain credit cards. Corporations often use them for syndicated loans, lines of credit, and some forms of corporate bonds for greater flexibility or lower initial borrowing costs.

What is the main risk of holding floating rate liabilities?

The main risk for a borrower holding floating rate liabilities is interest rate risk. This refers to the risk that market interest rates will rise, leading to higher interest payments and an increased cost of borrowing, which can strain a borrower's budget or profitability.