Variable-Rate Debt (Floating-Rate Debt)

Variable-rate debt (also known as 'floating-rate debt') is a type of loan where the interest rate is not fixed for the entire term. Instead, it periodically adjusts based on an underlying benchmark interest rate. Think of it like a boat tethered to a buoy in the ocean; as the tide (the benchmark rate) rises and falls, so does the boat (your interest payment). For borrowers, this can be a double-edged sword. When benchmark rates are low, their interest payments are cheap, making the debt seem attractive. However, when rates climb, so do their payments, potentially squeezing their cash flow and creating financial distress. This uncertainty is a crucial factor for any investor to analyze when looking at a company's financial health. Unlike the predictable, boring cousin, fixed-rate debt, which locks in a payment for the life of the loan, variable-rate debt introduces a significant element of guesswork and risk into a company's future obligations.

The interest rate on a floating-rate loan isn't just pulled out of thin air. It’s typically made of two distinct parts:

• The Benchmark: This is a market-based reference rate that reflects general economic conditions. It’s the “floating” part of the equation. Common benchmarks include:
  • The SOFR (Secured Overnight Financing Rate) in the United States.
  • The EURIBOR (Euro Interbank Offered Rate) in the Eurozone.
• The Spread: This is a fixed percentage added on top of the benchmark rate. The spread represents the lender's profit margin and compensates them for the borrower's specific credit risk. A financially shaky company will have to pay a much wider spread than a rock-solid blue-chip corporation.

So, the total interest rate is calculated as: Benchmark Rate + Spread. For example, if a company borrows money at “SOFR + 2%,” and the current SOFR is 3%, their interest rate would be 5%. If SOFR jumps to 4.5% at the next reset period, their new interest rate becomes 6.5%, increasing their interest expense without the company taking on any new debt.

For a disciple of value investing, debt is not inherently evil, but unpredictable debt is a major red flag. The core philosophy, championed by figures like Warren Buffett, revolves around buying wonderful businesses at fair prices, and a key characteristic of a wonderful business is predictable earnings. Variable-rate debt directly attacks this predictability.

When a company loads up its balance sheet with floating-rate debt, it's making a bet on the future direction of interest rates. This is speculation, not sound business management.

• The Seductive Trap: In low-interest-rate environments, managers might be tempted by the low initial payments of variable-rate loans to juice short-term profits. A value investor sees this not as clever financing, but as a potential sign of a weak or short-sighted management team.
• Eroding the Margin of Safety: The most sacred concept in value investing is the margin of safety—a buffer that protects against errors in judgment or bad luck. A heavy reliance on floating-rate debt shrinks this buffer. A sudden spike in interest rates can cause interest payments to balloon, wiping out profits and, in extreme cases, threatening the company’s solvency. The business becomes fragile, susceptible to economic forces outside its control.

How you view variable-rate debt depends on whether you're buying the company's stock or its debt.

• As a Shareholder: Be extremely cautious of companies with high levels of floating-rate debt, especially when inflation is rearing its head and central banks are likely to raise rates. Scour the company's annual report for details on its debt structure. A business that relies on floating rates is introducing a major risk factor that could hammer its stock price down the road.
• As a Lender (Bondholder): The picture is a bit different here. If you buy a floating-rate note (FRN), your income actually increases as benchmark rates rise. This can seem like a great way to protect your investment returns from inflation. However, you are not immune to risk! You've simply traded interest rate risk for increased credit risk. The very rate hike that benefits you as a lender could be the final nail in the coffin for the company borrowing the money, leading to a default where you could lose your entire principal.

Variable-rate debt introduces uncertainty and risk. While it might offer short-term benefits to a borrower in a falling-rate environment, it creates significant vulnerability when the economic tides turn. A prudent investor seeks stability, predictability, and a wide margin of safety. Companies that finance themselves heavily with floating-rate debt are often sacrificing these very qualities, making them less attractive candidates for a long-term investment portfolio. Always check the fine print on a company's debt—it tells you a lot about the risks management is willing to take with shareholders' money.