Floating Rate Bonds: Definition and How It Works

Floating rate bonds or floaters come with variable interest rates. Unlike fixed interest rate bonds, these bonds offer variable returns on investments. The variable interest rates adjust periodically with the Fed Funds Rate or LIBOR. These bonds can adjust interest rates on a daily, weekly, monthly, or quarterly basis.

Deeper Definition

Traditionally, bonds are considered fixed-rate debt instruments. Some companies, corporations, and government entities have started to issue variable interest rate bonds as well. These bonds comprise a fixed spread plus the Fed Fund Rate or LIBOR. Since LIBOR or the Fed Fund Rate change periodically, the floating rate bond will eventually adjust its interest rate as well.

The floating rate bonds or floaters are benchmarked against the short-term interest rates. Since the interest rates adjust periodically, it eliminates the interest rate risks for investors. Investors expect the Fed Fund Rate or LIBOR to rise over a long time. However, it isn’t necessarily the case with each floater.

How Does Floating Rate Bond Works?

Normally, bonds offer fixed interest rates. Floating rate bonds follow the benchmarked Fed or LIBOR interest rate. These bonds include the two-part interest rate. It includes a fixed spread and the Fed or LIBOR interest rate.

For example, if the current Fed Fund Rate is 1.5% and the bond issuer offers a spread of 0.50%, the Floating bond will have an interest rate of 2.0%. The spread offered by the issuer will remain the same over the bond’s lifetime, the adjustment will follow the Fed or LIBOR rate fluctuations. Floaters adjust the interest rates periodically. Since it reduces the interest rate risks, Floaters are deemed to be safer investments. Hence bond issuers offer lower interest rates on floating bonds.

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Since these bonds follow the central bank or the Fed interest rates, they also are effective as inflation-adjusted instruments. It is another factor that makes these bonds relatively safer investment, hence come with a lower yield on investment.

Bonds tend to adjust conversely in interest rate movements. If the interest rates fall, bonds increase their market value and vice versa. Investors put their money in floating rate bonds in anticipation of increasing interest rates in the future. If the Fed or LIBOR increases, so does the Floater’s interest rate. However, it does not happen all the time.

Special Considerations with Floating Rate Bonds

Floating rate bonds can be issued by any company or corporation. The US Treasury has also started issuing these bonds recently. However, some companies issue these bonds in financial distress. These bonds would get poor credit ratings from the top credit rating agencies. In that sense, the floaters would act similarly to junk bonds sans high yield on investment.

An advantage of floaters is their adjustability with market interest rates. It also reduces the opportunity cost risk for investors. Floaters can follow the inflation curve as well. These factors make floaters a relatively safer investment instrument than other bonds.

The bond issuer would disclose the frequency of periodic interest rate adjustments. Investors must keep an eye on the frequency since floaters tend to follow the short-term Fed Fund Rates. The variable interest factor also means investors would face inconsistent coupon payments. It’s a drawback with investments in bonds since investors look for consistency with fixed income through bonds.

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Much like other types of bonds, floaters also possess the default risk at maturity. Many floating rate bonds are issued by companies with a poor rating that increases the default risk of bonds. The overall rating of floating-rate bonds largely depends on the financial stature of the bond issuer. It also counts towards the interest rates on offer.

Advantages of Floating Rate Bonds

These bonds offer several advantages to bond issuers and investors alike.

  • Floaters can adjust to the interest rates hence an increase in price in the long run.
  • These bonds are less volatile to market conditions since they follow the Fed Fund Rate.
  • These bonds can be used as inflation-adjusted debt instruments.
  • Bonds reduce opportunity cost risk and interest rate risk for investors.

Disadvantages of Floating Rate Bonds

These bonds carry some risks and disadvantages as well.

  • Variable interest rates do not tend to rise all the time, which can severely reduce returns on investment for bondholders.
  • These bonds often carry higher default risks than fixed-income bonds.
  • Floaters offer inconsistent coupon payments since interest rates adjust periodically.
  • These bonds offer a lower yield on investment than fixed-income bonds.

Conclusion

Floating rate bonds come with variable interest rates that follow the Fed or LIBOR rates. These bonds pay inconsistent coupon payments. Investors can benefit from the increasing interest rates over the long term. However, these bonds carry default risk as other bonds.

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