====== Floating-Rate Debt ======
Floating-Rate Debt (also known as 'variable-rate debt' or 'adjustable-rate debt') is a type of loan or bond where the interest rate is not fixed for its entire term. Instead, it periodically adjusts based on the movements of an underlying financial [[benchmark]]. Think of it as a financial chameleon, changing its color (interest rate) to match its surroundings (the broader economic environment). Unlike traditional [[fixed-rate debt]], where the interest payment is predictable and unchanging, a floating-rate loan introduces uncertainty for the borrower. When the benchmark rate rises, so do the interest payments, increasing the cost of borrowing. Conversely, when the benchmark falls, the payments become cheaper. This structure effectively transfers the [[interest rate risk]]—the risk that changes in interest rates will negatively impact an entity—from the lender to the borrower. For the borrower, it's a bet that interest rates will stay low or fall; for the lender, it's a way to ensure their lending income keeps pace with the market.
===== How Does It Work? =====
At its core, a floating rate isn't just a single, randomly moving number. It's a simple and transparent formula.
==== The Anatomy of a Floating Rate ====
The interest rate a borrower pays is typically made up of two distinct parts:
  * **The Benchmark Rate:** This is the //variable// component. It's a well-known, independently set interest rate that reflects the general cost of borrowing in the financial system. Common benchmarks include the [[SOFR]] (Secured Overnight Financing Rate) in the U.S. or [[EURIBOR]] (Euro Interbank Offered Rate) in Europe. When you hear on the news that the central bank, like the [[Federal Reserve]], has raised rates, these are the types of benchmarks that are directly affected.
  * **The Spread:** This is the //fixed// component. It's an additional percentage added on top of the benchmark rate. The spread, also called a margin, does not change over the life of the loan. It serves as compensation for the lender for taking on the borrower's unique [[credit risk]]—the risk that the borrower won't be able to pay them back. A financially strong, blue-chip company will command a very small spread, while a riskier, more indebted company will have to pay a much wider spread.
**A Simple Example:** Imagine a company takes out a loan with an interest rate of SOFR + 2%. If SOFR is currently 3%, the company pays a total of 5% in interest. If, six months later, SOFR rises to 4%, the company's interest rate automatically adjusts to 6% (4% + 2%) at the next reset date.
==== Rate Resets and Caps/Floors ====
The interest rate doesn't change every second of every day. The loan agreement specifies "reset dates"—typically every three, six, or twelve months—on which the rate is adjusted to the current benchmark. To manage the uncertainty this creates, some loans include protective features:
  * **[[Interest Rate Cap]]:** This is a ceiling on the interest rate, protecting the borrower from a worst-case scenario where rates skyrocket. For example, a loan might have a cap of 10%, meaning the rate can never go higher, no matter how high the benchmark rises.
  * **[[Interest Rate Floor]]:** This is the opposite—a minimum interest rate that protects the lender. It ensures that even if the benchmark rate falls to zero, the lender still receives a minimum level of income.
===== A Value Investor's Perspective =====
For a value investor, understanding a company's debt is just as important as understanding its assets. Floating-rate debt adds a layer of complexity that must be carefully analyzed.
==== Analyzing a Company with Floating-Rate Debt ====
When you find a company loaded with variable-rate debt, your antennae should go up. It represents a significant, often hidden, risk.
  * **Stress Testing for Safety:** A prudent investor must "stress test" the company's income statement. Ask yourself: Can this company still comfortably cover its interest expenses if rates rise by 1%, 2%, or even 5%? If a moderate rate hike would wipe out the company's profits, it lacks a sufficient [[margin of safety]] and may be a fragile investment.
  * **Predictability is King:** Value investors prize businesses with predictable earnings. Floating-rate debt makes a company's interest expense volatile, which in turn makes its [[net income]] less stable and harder to forecast. This uncertainty can make it difficult to confidently determine the company's intrinsic value.
==== As an Investment (Floating-Rate Notes) ====
You can also be on the other side of the transaction by investing in [[floating-rate notes]] (FRNs), which are bonds that pay a variable interest rate.
  * **The Pro: A Hedge Against Rising Rates:** The main appeal of FRNs is their behavior in a rising-rate environment. When rates go up to combat [[inflation]], the value of fixed-rate bonds falls. However, the interest payments from an FRN increase, helping to protect your investment's income and principal value from the erosive effects of both rising rates and inflation.
  * **The Con: Credit Risk Remains:** While you are protected from interest rate risk, you are fully exposed to credit risk (also known as [[default risk]]). If the company or government that issued the note gets into financial trouble, its price can plummet, regardless of what interest rates are doing. Always remember: the "float" in the rate doesn't protect you if the issuer sinks.
===== A Real-World Analogy =====
The easiest way to understand corporate floating-rate debt is to think about an **[[adjustable-rate mortgage]] (ARM)**, a common type of home loan.
When a family takes out an ARM, they might get a lower initial "teaser" rate than they would with a fixed-rate mortgage. This makes the initial payments more affordable. However, they are taking on the risk that their mortgage payments could jump significantly in the future if interest rates rise. This creates uncertainty in their household budget.
A company with floating-rate debt is in the exact same boat. It may enjoy lower interest costs today, but it has traded long-term predictability for short-term savings. For a value investor, that's often a poor trade-off.