Understanding Floaters: Types, Benefits, and Key Investment Considerations

What Is a Floater?

A floater, or floating rate note (FRN), is a bond with variable interest payments tied to a benchmark index like SOFR or Treasury rates, adjusting with market conditions. Unlike fixed-rate notes, which pay constant interest, floaters rise or fall as rates change, offering investors protection against rising interest rates. Some floaters include caps and floors to limit rate fluctuations, making them a flexible tool within a fixed-income strategy.

How Floating Rate Notes Work

A floater is a fixed-income security with coupon payments based on a reference rate, adjusted as market interest rates change.

When interest rates rise, the value of the coupons is increased to reflect the higher rate.

Other reference or benchmark rates include the Euro Inter-bank Offer Rate (EURIBOR), federal funds rate, and US Treasury rates. For example, a floater bond's coupon might be the "three-month T-bill rate plus 0.5%," with payments made monthly, quarterly, semi-annually, or annually.

Floaters are based on short-term rates, usually lower than long-term ones, so they typically pay less interest than similar fixed-rate notes. If the perception of the creditworthiness of the issuer turns negative, investors may demand a higher interest rate at, say the three-month T-bill rate plus 0.75%.

A floater is more beneficial to the holder as interest rates are rising because it allows a bondholder to participate in the upward movement in rates since the coupon rate of the bond will be adjusted upwards. Investors who choose floaters are willing to accept a lower initial rate in exchange for the possibility of a higher rate if market rates rise.

The unpredictability of the coupon rates is the main reason that floaters carry lower yields than fixed rate notes of the same maturity. Conversely, a floater is less advantageous to the holder when rates are decreasing because the payments they receive may be lower than the fixed rate they could have had.

Key Features and Considerations for Floating Rate Notes

Most floaters will come with both a ceiling (cap) and a floor, which allows an investor to know the maximum and/or minimum interest rate the note will pay. A cap is the maximum interest rate that the note can pay, regardless of how high the benchmark rate climbs, and protects the issuer from escalating interest rates.

A floor, by comparison, is the lowest allowable payment and protects the investor from a severe decline in interest rates. A floater’s interest rate can change as often or as frequently as the issuer chooses, from once a day to once a year. This is intended to protect investors from falling interest rates.

Floaters will also have a reset period, which tells the investor how often the rate adjusts. For instance, many floaters adjust on an annual, semi-annual, or quarterly basis.

Understanding Inverse Floaters and Their Impact

One type of floater that may be issued is called the inverse floater. The coupon rate on an inverse floater varies inversely with the benchmark interest rate. The coupon rate is calculated by subtracting the reference interest rate from a constant on every coupon date. When the reference rate goes up, the coupon rate will go down since the rate is deducted from the coupon payment.

A higher interest rate means more is deducted, thus, less is paid to the debt holder. Similarly, as interest rates fall, the coupon rate increases because less is taken off. To prevent a situation whereby the coupon rate on the inverse floater falls below zero, a restriction or floor is placed on the coupons after adjustment. Typically, this floor is set at zero.

The Bottom Line

Floaters are bonds with interest payments tied to benchmarks like SOFR or Treasury rates, offering protection in rising-rate environments compared with fixed-rate notes. Though they may start with lower yields, caps and floors help limit swings in payments.

Many investors use floaters when rates are expected to climb, while inverse floaters move opposite benchmark rates and usually include a floor to avoid negative interest.