Floating rate bonds, also known as variable or adjustable rate bonds, are debt instruments whose interest rate is not fixed but rather adjusts periodically according to a predetermined formula. This interest rate is typically linked to an underlying interest rate index, such as the London Interbank Offered Rate (LIBOR) historically, or more commonly now, the Secured Overnight Financing Rate (SOFR) or other benchmark rates.
These bonds offer a dynamic interest payment that changes over time, contrasting with traditional fixed-rate bonds that pay the same interest throughout their lifetime.
How Floating Rate Bonds Work
The core mechanism of a floating rate bond (FRB) is its variable coupon payment. Instead of a static interest rate, the bond's coupon rate resets at regular intervals—for example, quarterly or semi-annually—based on a specified benchmark rate plus a fixed spread.
- Benchmark Rate: This is the base rate that reflects current market interest rates. Examples include SOFR, Euribor, or a country's treasury bill rate.
- Spread (or Margin): This is a fixed number of basis points (one basis point equals 0.01%) added to the benchmark rate. It compensates the investor for the credit risk of the issuer and the bond's specific characteristics.
For instance, if a floating rate bond's coupon formula is "SOFR + 0.50%", and SOFR is currently 4.00%, the bond's interest rate for that period would be 4.50%. If SOFR rises to 4.25% in the next period, the coupon rate would adjust to 4.75%.
Key Features and Characteristics
Floating rate bonds are distinct from fixed-rate bonds in several ways:
| Feature | Floating Rate Bonds (FRBs) | Fixed Rate Bonds |
|---|---|---|
| Interest Rate | Variable; adjusts periodically | Fixed; remains constant |
| Linkage | Tied to an interest rate index (e.g., SOFR) | Not tied to an index after issuance |
| Interest Rate Risk | Lower interest rate risk (duration) for investors | Higher interest rate risk (duration) for investors |
| Coupon Payments | Change with market rates | Predictable, steady payments |
| Price Volatility | Generally less volatile due to rate adjustments | More volatile in response to rate changes |
Common Characteristics:
- Reset Dates: Specific dates when the coupon rate is recalculated.
- Caps and Floors: Some FRBs may have an upper limit (cap) on how high the interest rate can go or a lower limit (floor) on how low it can drop, providing some predictability.
- Issuers: Governments, corporations, and financial institutions frequently issue FRBs.
Why Investors Choose Floating Rate Bonds
Floating rate bonds are often favored by investors who anticipate rising interest rates or seek to mitigate interest rate risk.
Advantages for Investors:
- Inflation Protection: As market interest rates often rise during periods of inflation, the coupon payments on FRBs tend to increase, providing investors with some protection against the erosion of purchasing power.
- Reduced Interest Rate Risk: Unlike fixed-rate bonds, whose prices fall when interest rates rise, FRBs adjust their coupon payments upward. This helps to stabilize their market price, as the yield remains competitive with current market rates.
- Diversification: They can offer a valuable diversification tool within a bond portfolio, especially when market forecasts suggest rate hikes.
Disadvantages for Investors:
- Lower Returns in Declining Rate Environments: If market interest rates fall, the coupon payments on FRBs will decrease, leading to lower income for the investor.
- Complexity: Their variable nature can make them slightly more complex to understand and value compared to fixed-rate bonds.
- Spread Risk: The spread over the benchmark rate can change if the issuer's credit quality deteriorates, potentially affecting the bond's value.
Risks Associated with Floating Rate Bonds
While FRBs reduce interest rate risk for investors, they are not without other risks:
- Credit Risk: The risk that the bond issuer will default on its interest or principal payments. This risk is present in all corporate bonds.
- Liquidity Risk: Some less frequently traded FRBs might be difficult to sell quickly without affecting their price.
- Basis Risk: If the investor's borrowing costs are tied to a different index than the bond's coupon, there could be a mismatch.
Who Issues and Invests in FRBs?
- Issuers: Large corporations, banks, and governments often issue floating rate bonds to manage their debt obligations, especially when they prefer to borrow at rates that reflect current market conditions. They might issue FRBs if they believe interest rates will fall or remain stable, or if they want to attract investors looking for variable income.
- Investors: Financial institutions, money market funds, and individual investors seeking income and principal stability in a rising rate environment are typical buyers. They are also popular with investors who have short-term liabilities and want to match the duration of their assets to their liabilities.
Floating rate bonds provide a flexible investment option for those looking to participate in the bond market while adjusting to changing economic conditions and interest rate landscapes. For more general information on investing in bonds, you can refer to resources like Investor.gov.
