What it means
Every floating rate bond has two parts to its coupon: a reference rate that moves, such as SOFR or a central bank policy rate, and a fixed spread that reflects the borrower's credit risk. The spread is set at issue and normally stays constant for the bond's life.
The coupon is recalculated on scheduled reset dates, most often quarterly. Between resets the rate is fixed, which is why these instruments are sometimes described as a series of short-term loans stitched together.
For the investor, the attraction is protection against rising rates. Because the coupon catches up with the market at every reset, the bond's price tends to stay close to its face value instead of falling the way a long-dated fixed rate bond would.
For the issuer, the trade-off runs the other way. Floating rate debt is cheaper when rates fall but leaves the interest bill exposed if they rise, which is why treasurers often pair it with an interest rate swap to convert the exposure back to fixed.
Structures vary. Some bonds carry a floor that stops the coupon falling below a minimum, others a cap that limits how high it can go, and a few reset against an average of the reference rate over the period rather than a single observation.
In practice
Real-world examples.
Example
A utility issues $250,000,000 of five-year floating rate notes to fund a grid upgrade, expecting rates to fall. It pairs the issue with a partial swap so that half the exposure behaves like fixed rate debt if the forecast proves wrong.
Example
A corporate treasurer parks surplus cash in short-dated floating rate notes rather than fixed rate bonds. When the central bank raises rates twice in six months, the portfolio's income rises with them and its market value barely moves.
Example
An insurer holding a floating rate bond with a 2% coupon floor keeps earning 2% when the reference rate falls to 0.5%. The floor turns out to be worth far more than the slightly lower spread the insurer accepted at issue.
Think of it
“Floating rate bond has variable interest-coupon changes with market rates.
Formula
Calculation
Coupon rate = Reference rate + Spread. Periodic interest payment = Principal x Coupon rate / Number of payments per year.
A company issues $1,000,000 of floating rate notes paying quarterly at the reference rate plus a spread of 1.20%.
On the first reset date the reference rate is 4.60%, so the coupon rate is 4.60% + 1.20% = 5.80%.
Quarterly payment = $1,000,000 x 5.80% / 4 = $58,000 / 4 = $14,500.
Three months later the reference rate has fallen to 4.10%, giving a coupon rate of 4.10% + 1.20% = 5.30%.
Quarterly payment = $1,000,000 x 5.30% / 4 = $53,000 / 4 = $13,250.
The investor's income has dropped by $14,500 - $13,250 = $1,250 for that quarter, purely because the reference rate moved. Had the reference rate instead risen to 5.60%, the coupon would have been 6.80% and the payment $17,000.Case study
Seen in the real world.
This fictional and illustrative example concerns Ravensmoor Logistics, an invented haulage group that needed $60,000,000 to renew its fleet. Its bankers offered a fixed rate bond at 6.40% or floating rate notes at the reference rate plus 1.30%, with the reference rate then sitting at 4.50% for an all-in cost of 5.80%.
The floating option looked cheaper by 0.60 percentage points, worth about $360,000 in the first year. The finance director's concern was that the fleet contract locked Ravensmoor into fixed customer pricing for four years, so a rising interest bill could not be passed on.
Ravensmoor issued the floating notes but immediately swapped $40,000,000 of the exposure to fixed, keeping $20,000,000 floating. The illustrative takeaway is that the choice between fixed and floating is rarely about which rate is lower today; it is about whether the business has any way to absorb the rate moving against it.
Watch out
Common mistakes.
- Assuming a floating rate bond carries no risk. The interest rate risk is much reduced, but credit risk, liquidity risk and reinvestment risk are all still present.
- Thinking the spread moves with the market. The spread is fixed at issue; only the reference rate resets, so a deterioration in the issuer's credit shows up in the bond's price rather than its coupon.
- Forecasting income from a floating rate bond as if the current coupon will persist. Each reset can change the payment materially, as a 0.5 percentage point move on $1,000,000 shows.
Questions
People also ask.
How often does the coupon reset?
Quarterly is most common, though monthly, semi-annual and annual resets all exist and are set out in the bond's terms.
Why does a floating rate bond trade close to par?
Because the coupon adjusts to the market at each reset, there is little reason for the price to drift far from face value.
Is floating rate debt cheaper than fixed?
Often at the outset, since the borrower rather than the lender is carrying the rate risk, but the total cost over the life of the bond depends on where rates actually go.
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