What it means
A normal bond pays the same fixed coupon (the interest payment) for its whole life. A floater instead pays a coupon calculated as a reference rate plus a fixed margin, often called the spread.
The reference rate is a widely published benchmark for short-term borrowing, and it changes as market conditions change. The rate is reset on set dates, usually every one, three or six months.
Because the coupon follows the market, the bond's price tends to stay close to its face value (the amount repaid at maturity) rather than swinging up and down. This makes floaters less sensitive to interest rate risk than fixed-rate bonds of the same maturity.
Floaters are popular with banks, corporate treasurers and money market funds that want to earn income without taking big price risk. Companies and governments issue them because they can borrow at a cost that follows the market, and banks often issue them to fund variable-rate loans.
When rates rise, investors benefit from higher income, and when rates fall, income declines. The margin over the reference rate reflects the credit quality of the issuer.
A strong borrower pays a small margin, while a weaker one must pay more to attract investors. This means a floater still carries credit risk, which is the chance the issuer fails to repay.
Some floaters have extra features such as a cap, which limits the maximum coupon, or a floor, which guarantees a minimum coupon. A cap helps the issuer and hurts the investor, while a floor does the opposite.
Always read the terms to see what protection you actually have. There is also a nuance around timing.
Between reset dates, the bond's coupon is fixed for that period, so a sudden rise in rates will not lift income until the next reset. The longer the gap between resets, the more the bond behaves like a fixed-rate bond in the meantime.
In practice
Real-world examples.
Example
A corporate treasurer places $2,000,000 of surplus cash in a two-year floater. When central bank rates rise, her interest income rises at the next reset, and the bond price barely moves.
Example
A regional bank issues floating-rate notes to fund its variable-rate mortgage book. The coupons it pays investors rise and fall with the same reference rate that drives the income from its borrowers.
Example
A pension fund holds floaters as a defensive part of its portfolio during a period when interest rates are expected to climb. The fund prefers steady income over the chance of price gains.
Formula
Calculation
Coupon rate = Reference rate + Margin
Periodic coupon payment = Face value x Coupon rate / Number of payments per year
Suppose a company holds a $1,000,000 floater paying quarterly, with a reference rate of 3.50% and a margin of 0.75%. The coupon rate is 3.50% + 0.75% = 4.25%. The quarterly payment is 1,000,000 x 0.0425 / 4 = $10,625. If the reference rate rises to 4.50% at the next reset, the coupon rate becomes 5.25% and the quarterly payment is 1,000,000 x 0.0525 / 4 = $13,125.Case study
Seen in the real world.
Westbrook Engineering is an illustrative, fictional manufacturer that held $3,000,000 in fixed-rate bonds when market interest rates began to rise. The market value of the bonds fell, and the finance director was unhappy to see a paper loss on money meant to be safe.
She sold the bonds and reinvested in floating-rate notes from highly rated issuers. Over the next year, the coupons increased with each reset and the price of the notes stayed close to their face value.
The illustrative result was a lower yield at the start, since floaters often pay less than long fixed-rate bonds, but steadier results. The board agreed that stability was worth more than the extra yield for cash held for a planned acquisition.
Watch out
Common mistakes.
- Assuming a floater has no risk, when the issuer can still default and the price can fall if its credit quality worsens.
- Forgetting that a cap on the coupon can stop income rising even when market rates continue to climb.
- Comparing the coupon of a floater with a fixed-rate bond without allowing for the fact that the floater's coupon will change.
Questions
People also ask.
What is a floater linked to?
A short-term reference rate such as a widely published interbank or overnight rate, which is stated in the bond's terms.
Are floaters good when interest rates fall?
They are less attractive then, because the coupon falls at each reset and the investor loses the locked-in income that a fixed-rate bond would have provided.
How often does the rate on a floater change?
It resets on dates set in the bond terms, commonly every one, three or six months.
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