A floating rate bond (also known as a “floater”) is a bond that has a variable coupon, tied to a benchmark or reference rate, like the London Interbank Offered Rate (LIBOR), the U.S. Treasury bill rate, or the fed funds, plus an additional spread. The reference rate will fluctuate throughout the life of the security, but the quoted spread remains constant. For example, a rate could be quoted as 3-month USD LIBOR + 0.20%; if LIBOR stood at 0.25%, the rate would be 0.45%.
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While the yield changes as prevailing interest rates fluctuate, the spread (the “+0.20” in the example above) stays the same. Spreads on floating rate bonds are based on a number of factors, including the credit quality of the issuer and the time till maturity. The reset period determines the frequency at which the yield of floating rate note is adjusted to reflect the current reference rate. The reset rate may be daily, weekly, monthly, quarterly, or every six, or twelve months, depending on the characteristics of the benchmark index or the terms of the bond. Floating rate bonds are mainly issued by corporations, municipalities, and government sponsored enterprises, and they typically have a two to five-year term to maturity. Interest payments on floaters may be made monthly, quarterly, or annually. In the United States, the Federal National Mortgage Association (Fannie Mae) is a major issuer of floating rate bonds.
Floating rate bonds are ideal for investors who believe that interest rates and inflation may rise, and are dissatisfied with the current low short-term rates. The best time to buy a floating rate bond is when interest rates have fallen quickly in a short period, and are expected to rise in the future. Conversely, fixed-rate bonds are more attractive when prevailing rates are high and are expected to fall. Floating rate bonds are also suited for investors whose primary concern is to maintain a portfolio return that keeps up with inflation. Since floating rate bonds tend to be targeted to large institutional investors, with high minimum investment amounts, the easiest way for an individual investor to invest is through an exchange-traded fund. The investor can get access to the market for a smaller dollar amount, and will enjoy a greater degree of diversification than by just buying a few individual issues.
As with all investment instruments, floating rate bonds have their inherent risks too. If the prevailing interest rates go down steeply, investors in floating rate securities will receive lower income because their yield will adjust downward. Also, investors in floating rate bonds are uncertain about the future income stream of their investments. In contrast, an owner of a plain-vanilla bond knows exactly what he or she will be paid at the bond’s maturity. Moreover, floaters carry lower yields than fixed-rate debt instruments of the same maturity. The coupon payments are also unpredictable, though if the bond has a floor and a cap, the investor will know the maximum and minimum interest rate the bond might pay.Want to learn how to generate more income from your portfolio so you can live better? Get our free guide to income investing here.