Floating-Rate Security

A floating-rate security (also known as a 'floater' or a 'floating-rate note (FRN)') is a type of debt investment, typically a bond, whose interest payment is not fixed for its entire life. Instead, the payment, known as the coupon, periodically adjusts based on the movements of an underlying benchmark interest rate. Think of it like a small boat tied to a buoy in the ocean; as the tide (the benchmark rate) rises and falls, so does the boat (your interest payment). This dynamic feature is what separates it from a traditional fixed-rate security, which pays the same interest amount year after year, like a lighthouse standing at a constant height regardless of the tide. The coupon payment for a floater is typically calculated by taking a well-known benchmark rate, such as SOFR (Secured Overnight Financing Rate) in the U.S. or Euribor in Europe, and adding a fixed additional percentage on top, known as the spread. This structure makes floaters a popular tool for investors looking to protect their portfolio from the effects of changing interest rates.

The magic of a floater lies in its simple but powerful formula. Understanding this mechanism helps you see why it behaves the way it does in different economic climates.

At its heart, the interest you receive from a floating-rate security is determined by a straightforward equation: Coupon Rate = Benchmark Rate + Spread The benchmark rate is the variable part of the equation. It's a widely recognized market rate that reflects the current cost of borrowing money. The spread (or margin) is a fixed percentage added to the benchmark. It is determined when the security is first issued and generally reflects the credit risk of the issuer—the higher the risk, the larger the spread investors will demand as compensation. For example: Imagine you buy a floater from ACME Corp. that pays SOFR + 1.5%. The rate adjusts, or “resets,” every three months.

• If SOFR is 3.0% at the beginning of a quarter, your interest rate for that period will be 3.0% + 1.5% = 4.5%.
• If, three months later, the central bank has raised rates and SOFR has climbed to 4.0%, your interest rate for the next quarter automatically adjusts to 4.0% + 1.5% = 5.5%.

Not all floaters are created equal. When evaluating one, it's crucial to look for a few key features that can significantly impact your returns and risk exposure:

• Coupon Cap: This is the maximum interest rate the security can ever pay. It's a ceiling that protects the issuer from having to make sky-high payments if benchmark rates soar unexpectedly. For the investor, it limits potential upside.
• Coupon Floor: This is the minimum interest rate the security will pay, even if the benchmark rate plus the spread falls below this level. This floor protects the investor's income in a falling-rate environment.
• Reset Period: This is the frequency with which the coupon rate is recalculated (e.g., daily, monthly, quarterly). A shorter reset period means the security's interest payments will adapt more quickly to changes in market rates.

For a value investor, whose primary goal is capital preservation and achieving a reasonable return, floating-rate securities can be a valuable tool, particularly when used strategically.

The main appeal of floaters is their performance in a rising interest rate environment. When central banks are raising rates to combat inflation, traditional fixed-rate bonds lose market value. Why? Because newly issued bonds will offer higher fixed coupons, making older, lower-paying bonds less attractive. This is a classic example of interest rate risk. Floaters, however, sidestep much of this risk. Because their coupon payments rise along with benchmark rates, their income stream remains competitive. As a result, their market price tends to be much more stable than that of fixed-rate bonds. For a value investor, this price stability is a huge plus, as it helps preserve the principal value of the investment while still generating a growing stream of income. They are an excellent way to park cash that you want to keep relatively safe and liquid, while earning more than a standard savings account.

While useful, floaters are not risk-free. A prudent investor must consider the downsides:

1. Falling Interest Rates: The flip side is that in a declining-rate environment, the income from your floater will decrease with each reset. Your income stream shrinks, and if there's no coupon floor, it could become very small.
2. Credit Risk: This is the risk that the issuer of the security will be unable to make its interest payments or repay the principal at maturity (also known as default risk). This risk is tied to the financial health of the issuer, not the floating-rate structure itself. The spread is your main compensation for taking on this risk.
3. Liquidity Risk: Some floaters, especially those issued by smaller or less-known entities, may be thinly traded. This means it might be difficult to sell your security quickly without accepting a lower price.
4. Benchmark Risk: The underlying benchmark itself can pose a risk. The recent multi-year phase-out of the once-dominant LIBOR benchmark and the transition to new rates like SOFR created uncertainty for holders of older securities. Always be aware of the health and longevity of the benchmark your security is tied to.