Inverse Floaters: What Is It and How It Works?

An inverse floater is a type of bond that comes with an inverse relation to a benchmark interest rate. Unlike a floater, an inverse floater’s coupon rate goes in the opposite direction to the benchmark interest rate.

An inverse floater is a variable interest rate security that follows the benchmark interest rate in the opposite direction. Inverse floaters carry interest rate risks. However, investors can use inverse floaters for hedging and interest rate payments in highly volatile interest rate markets.

What is an Inverse Floater?

An inverse floating rate note or simply called an inverse floater is a debt instrument (typically a bond) whose coupon payment follows an opposite direction to that of a benchmark interest rate.

Corporate entities and government institutions issue inverse floaters to raise capital. They can set a particular interest rate as a benchmark rate such as LIBOR, EURIBOR, or US treasury rate. The coupon rate of an inverse floater would move in the opposite direction of the chosen benchmark rate.

How Does an Inverse Floater Work?

Issuers of inverse rate floaters can choose a benchmark interest rate. The coupon payments would adjust periodically in inverse relation to that interest rate. It means when the benchmark rate increases, the coupon rate of inverse floater will decrease and vice versa.

Investors receive periodic coupon payments after adjustments are made for the inverse relation. Typically, investors would look for an inverse floater in a low-interest rate market and anticipate a further decrease in the future.

The coupon rate of the inverse floater is fluctuation over the life of the note. It can be calculated by subtracting the reference interest rate from a constant rate periodically.

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The formula to calculate the coupon rate of an inverse floater is given below.

Coupon Rate = Fixed Rate – (Coupon Leverage × Benchmark Interest Rate)

The fixed rate here is the fixed interest rate of the bond. The benchmark rate can be LIBOR or US treasury rate as decided by the issuer.

The coupon leverage changes with the change in the reference interest rate. For instance, it can be set at 2 times the reference rate if it is below 3% and 1.5 if the reference rate increases to 5%.

Example

Let us consider a simple example of an inverse rate floater to understand the concept.

Suppose a company ABC issues an inverse floater to raise capital of $ 1 million. It sets the reference rate as the US treasury rate, say, 2% currently. The coupon leverage is initially set at 2 times the US treasury rate.

If the fixed interest rate of the bond is 8%, we can calculate the coupon rate of the inverse floater as below.

Coupon Rate = Fixed Rate – (Coupon Leverage × Benchmark Interest Rate)

Coupon Rate = 8% – (2×2%) = 4%.

We can see that if the benchmark or reference interest rate increases, the coupon rate of the inverse floater will decrease. For instance, if the US treasury rate increases to 3%, the inverse floater’s coupon rate decrease to 2% only. Similarly, if the US treasury rate decreases, say to 1%, the coupon rate will increase to 6%.

Special Considerations with Inverse Floaters

As the reference rate moves closer to the fixed interest rate, the coupon leverage multiplier will change. The coupon rate of the inverse floater can go negative if the benchmark rate and the leverage multiplier increase. Say at 1.5 coupon leverage and a US treasury rate of 6% in our example, the coupon rate will be –1%.

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Both parties can avoid this problem by setting caps and floors to the reference interest rates. Typically, the cap is set to the maximum fixed interest rate where the leverage also reduces to 1. Also, the floor is set to zero so that the coupon rate equals the fixed interest rate.

As the multiplier uses coupon leverage, it signifies the returns as well bond pricing. The bond pricing moves in the opposite direction of the coupon rate. Hence, using coupon leverage in an inverse floater also magnifies the bond valuation in a volatile market.

Advantages of Inverse Floaters

Inverse Floaters offer some advantages to investors and issuers.

  • Investors receive higher coupon rates than straight bonds.
  • Investors can use inverse floaters as hedging instruments to protect their investments against interest rate risks.
  • Issuers can take advantage of variable interest rates and lower their cost of borrowings.

Disadvantages of Inverse Floaters

Inverse floaters can offer some limitations as well.

  • Inverse floater magnifies the interest rate risks due to the use of coupon leverage multiplier.
  • Investors may receive lower returns than anticipated with variable interest rates.
  • Issuers may also face higher interest rate risks with inverse floaters.

Final Thoughts

Inverse floaters come with an inverse interest rate relationship. Their coupon rates move in the opposite direction to that of reference interest rates. Inverse floaters come with higher interest rates but make higher coupon payments as well.

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