What Are Floating Rate Securities?
Floating rate securities are debt instruments that feature an interest rate that adjusts periodically based on a predetermined benchmark or reference rate, plus a specified spread. Unlike traditional fixed-rate bonds, where the coupon payment remains constant throughout the life of the security, the interest payments on floating rate securities fluctuate in line with changes in the underlying reference rate. This characteristic makes floating rate securities a key component within the broader category of fixed income investments. Issuers, which include corporations, financial institutions, and governments, utilize floating rate securities to manage their borrowing costs, while investors seek them for their ability to offer protection against rising interest rates and to provide a dynamic income stream. These securities are also commonly known as floating rate notes (FRNs) or "floaters."
History and Origin
Floating rate notes originated in Europe and first appeared in the United States in 1974, with a notable $650 million issuance by Citicorp.21,20 While initial adoption in the U.S. saw periods of fluctuating popularity, they gained traction, particularly in the Eurobond market, accounting for a significant portion of new issues by the early 1980s.19 The U.S. Department of the Treasury introduced its own floating rate notes (FRNs) in 2014, marking the first new marketable Treasury security since Treasury Inflation-Protected Securities (TIPS) were introduced in 1997.18 These U.S. Treasury FRNs were designed to have a two-year maturity, pay interest quarterly, and base their interest rates on the highest accepted discount rate in the 13-week Treasury bills auction.17
The global financial industry has also seen a significant transition in benchmark rates. Historically, the London Interbank Offered Rate (LIBOR) was widely used as a reference rate for many floating rate securities and other financial contracts. However, due to concerns over its reliability and susceptibility to manipulation, global regulators initiated a phased transition away from LIBOR.16,15 The Secured Overnight Financing Rate (SOFR) was recommended as a preferred alternative for U.S. dollar-denominated contracts by the Alternative Reference Rates Committee (ARRC), formed by the Federal Reserve and the New York Federal Reserve.14,13 The Federal Reserve Board adopted a final rule in late 2022 to implement the Adjustable Interest Rate (LIBOR) Act, identifying SOFR-based rates as replacements for LIBOR in certain financial contracts after June 30, 2023.12
Key Takeaways
- Floating rate securities are debt instruments whose interest payments adjust periodically based on a benchmark rate plus a spread.
- They offer investors a defense against rising interest rates, as their coupon rates reset higher in such environments.
- Floating rate notes generally exhibit less price sensitivity to interest rate changes compared to fixed-rate bonds, contributing to greater price stability.
- These securities provide a variable income stream, making their future yield unpredictable but adaptive to market conditions.
- While offering interest rate protection, floating rate securities still carry credit risk and potential reinvestment risk if rates decline.
Formula and Calculation
The interest rate for a floating rate security is determined by its reference rate plus a spread. The coupon payment for a given period is calculated using the following formula:
Where:
- Reference Rate: A widely recognized short-term interest rate benchmark, such as the Secured Overnight Financing Rate (SOFR) or a Treasury bill rate.
- Spread: A fixed percentage or basis points added to the reference rate, reflecting the issuer's creditworthiness and market conditions at the time of issuance.
For example, if a floating rate security has a reference rate of 5.00% and a spread of 0.75% (75 basis points), the coupon rate for that period would be 5.75%. This rate then applies to the face value, or principal, of the security to determine the actual interest payment.
Interpreting Floating Rate Securities
Floating rate securities are interpreted primarily through their responsiveness to the prevailing interest rate environment. When interest rates rise, the coupon payments from floating rate securities generally increase, offering investors a hedge against inflation and the erosion of purchasing power. Conversely, when interest rates fall, the coupon payments will decrease.
Investors evaluate these securities by considering the chosen reference rate, the spread offered, the frequency of rate resets, and the issuer's credit quality. A higher spread typically compensates for higher perceived issuer risk or less favorable market conditions. The reset frequency, which can range from daily to annually, dictates how quickly the income stream adjusts to market changes. For example, a floating rate security with quarterly resets will adjust its income more frequently than one resetting semi-annually, making it more responsive to short-term rate movements. The inherent design of these securities means their market price tends to be more stable than fixed-rate alternatives, as their coupon payments adjust to maintain their attractiveness relative to current market rates, thereby reducing interest rate risk on the security's price.
Hypothetical Example
Consider an investor, Sarah, who purchases a floating rate security with a face value of $1,000, a quarterly interest payment schedule, and an interest rate tied to the Secured Overnight Financing Rate (SOFR) plus a spread of 100 basis points (1.00%). The initial SOFR is 4.00%.
For the first quarter, the coupon rate is calculated as:
Sarah receives a quarterly interest payment of ( $1,000 \times \frac{5.00%}{4} = $12.50 ).
Three months later, the SOFR rate rises to 4.50%. For the second quarter, the coupon rate resets:
Sarah's quarterly interest payment increases to ( $1,000 \times \frac{5.50%}{4} = $13.75 ).
If, in the third quarter, SOFR falls to 3.75%, the coupon rate would become:
Her quarterly interest payment would then be ( $1,000 \times \frac{4.75%}{4} = $11.875 ).
This example demonstrates how the income Sarah receives from her floating rate security adjusts with changes in the underlying benchmark, providing a dynamic income stream.
Practical Applications
Floating rate securities find various practical applications across different facets of investing, markets, and financial planning. They are commonly issued by corporations, banks, and governmental entities, including the U.S. Treasury, to raise capital.11,10 For investors, these securities serve as an important tool for portfolio management and risk mitigation, particularly in environments of rising interest rates.
- Inflation Protection: Because their interest rates adjust, floating rate securities can help investors maintain their real return during periods of rising inflation, as nominal interest rates often rise in response to inflationary pressures.
- Interest Rate Risk Management: Floating rate securities inherently possess lower duration compared to fixed-rate alternatives of similar maturity. This means their market price is less sensitive to shifts in overall interest rates, offering a degree of stability in a volatile bond market.9 This characteristic can be particularly appealing to investors concerned about potential capital losses on their fixed income holdings if interest rates were to climb.
- Cash Management: For institutional investors or individuals seeking to park cash in interest-bearing instruments while retaining flexibility, floating rate securities can offer a competitive yield that adjusts with short-term market rates, rather than locking into a fixed, potentially lower rate.
- Diversification: Including floating rate securities can contribute to the diversification of a fixed income portfolio, balancing the risks associated with fixed-rate bonds and providing a distinct return profile. The U.S. Securities and Exchange Commission (SEC) provides further information on floating rate notes and their characteristics.8
Limitations and Criticisms
While floating rate securities offer distinct advantages, they also come with certain limitations and criticisms that investors should consider.
One primary drawback is the potential for lower income in a declining interest rate environment. As the reference rate falls, the coupon payments from floating rate securities will also decrease, leading to reduced income for the investor.7,6 This contrasts with fixed-rate bonds, which continue to pay a consistent coupon regardless of market rate movements, making fixed-rate bonds more attractive if rates decline.
Another consideration is that floating rate notes typically offer lower initial yields compared to fixed-rate bonds of similar maturity, which can be less appealing to investors seeking immediate higher income.5,4 Additionally, while they protect against rising interest rates, floating rate securities are not entirely immune to market volatility. Their value can still fluctuate due to changes in market liquidity, credit spreads, or perceptions of the issuer's creditworthiness. For example, during periods of significant financial stress, such as the 2008-2009 global financial crisis, even investment-grade floating rate notes experienced price declines.3
Some floating rate securities may also carry call risk, meaning the issuer has the option to redeem the notes before their stated maturity, often when interest rates have fallen.2 This can lead to reinvestment risk for investors, who then may need to reinvest their principal at lower prevailing rates. The complexity of these instruments, particularly those with caps, floors, or other embedded options, can also make them more challenging for some investors to understand and analyze.1
Floating Rate Securities vs. Fixed-Rate Bonds
The fundamental difference between floating rate securities and fixed-rate bonds lies in how their interest payments are determined. Fixed-rate bonds pay a constant, predetermined interest payment over their entire life, regardless of how market interest rates change. This provides a predictable stream of income for investors. However, the market price of a fixed-rate bond is highly sensitive to interest rate fluctuations; when rates rise, the price of existing fixed-rate bonds typically falls, and vice versa.
In contrast, floating rate securities have an interest rate that periodically resets based on an external benchmark. This means their coupon payments will increase when interest rates rise and decrease when rates fall. This variable income stream makes floating rate securities less susceptible to price volatility caused by interest rate changes. Their market prices tend to remain relatively stable, close to their face value, because their yield adjusts to reflect current market conditions. The trade-off is that investors in floating rate securities forgo the certainty of a fixed income stream and may experience lower income during periods of declining interest rates, whereas fixed-rate bondholders would continue to receive their higher, locked-in coupon.
FAQs
What does "floating" mean in floating rate securities?
"Floating" refers to the interest rate on the security, which is not fixed but adjusts periodically based on a benchmark rate, such as SOFR, plus a set spread. This means the interest payments you receive will go up or down with market interest rates.
Are floating rate securities safe?
Floating rate securities, particularly those issued by stable governments like the U.S. Treasury, are generally considered to have low credit risk. However, like all investments, they carry some risks, including the credit risk of the issuer (the possibility they might default) and the risk of lower income if interest rates decline. They are not entirely risk-free.
How often do floating rate securities reset their interest rates?
The frequency of interest rate resets for floating rate securities varies by the specific security. Some may reset daily or weekly, while others reset quarterly, semi-annually, or annually. This "reset period" is defined in the security's terms.
Who issues floating rate securities?
Floating rate securities are issued by a variety of entities, including national governments (like the U.S. Treasury), government-sponsored enterprises, corporations, and banks. They are a way for these entities to borrow money from investors.
Why would an investor choose a floating rate security over a fixed-rate bond?
An investor might choose a floating rate security to protect their investment income from rising interest rates. If rates go up, their payments will increase, helping to offset the impact of inflation. They also typically experience less price volatility than fixed-rate bonds when interest rates change, offering greater price stability.