Floating-Rate

A Floating-Rate (also known as a 'Variable-Rate' or 'Adjustable-Rate') is an interest rate that isn't locked in for the life of a loan or security. Instead, it periodically adjusts, moving up or down to reflect changes in a specific, underlying benchmark. Think of it like a small boat tied to a large buoy in the ocean; as the tide (the benchmark rate) rises and falls, so does the boat (your interest rate). This mechanism is common in various financial instruments, from corporate debt to home mortgages. The rate is typically calculated as the benchmark rate plus a fixed margin, or spread. For example, a loan might have a rate of 'SOFR + 2%'. If SOFR is 3%, the borrower pays 5%. If SOFR climbs to 4%, the borrower's rate automatically adjusts to 6%. This dynamic nature makes floating-rate instruments behave very differently from their fixed-rate counterparts, especially in changing economic climates.

At its heart, a floating rate is a simple formula: Benchmark Rate + Spread = Your Interest Rate. Understanding these two components is key to understanding how your returns (or payments) will behave.

The benchmark is the 'floating' part of the equation. It's a reference interest rate that is independent and publicly available, reflecting general market conditions. When you hear financial news about central banks raising or lowering rates, these are the kinds of benchmarks that are affected.

• Common Examples: Historically, the most famous benchmark was the London Inter-bank Offered Rate (LIBOR), but it has been largely phased out due to manipulation scandals. Today, you'll most commonly see:
  • SOFR (Secured Overnight Financing Rate): The primary replacement for LIBOR, based on transactions in the U.S. Treasury repurchase market.
  • Federal Funds Rate: The rate at which U.S. banks lend to each other overnight, heavily influenced by the Federal Reserve.
  • Euribor (Euro Interbank Offered Rate): A key benchmark for Euro-denominated products.

The spread is the 'fixed' part of the equation. It's an extra percentage added on top of the benchmark, also called a margin. This spread doesn't change for the life of the loan. It primarily represents the lender’s compensation for taking on the risk of lending to a specific borrower.

• What it means: A blue-chip, financially sound company might borrow at SOFR + 0.5%, while a riskier, more indebted company might have to pay SOFR + 4.0%. The wider the spread, the higher the perceived risk of default. As an investor buying a floating-rate bond, this spread is your reward for taking that risk.

You'll encounter floating rates in several corners of the investment world.

1. Floating-Rate Notes (FRNs): These are bonds that pay a variable coupon payment. Instead of a fixed 4% coupon each year, an FRN might pay a coupon of the 3-month SOFR + 1%, which resets every three months.
2. Adjustable-Rate Mortgages (ARMs): A common consumer product. ARMs often lure borrowers with a low 'teaser' fixed rate for a few years, after which the rate begins to float based on a benchmark, subjecting the homeowner to potentially higher payments.
3. Leveraged Loans: These are loans made to companies that already have a significant amount of debt. Due to their higher risk profile, they are almost exclusively issued with floating rates.

For a value investor, floating-rate securities are a tool, and like any tool, they must be used with a clear understanding of their purpose and risks.

The main appeal of owning floating-rate assets is their built-in protection against interest rate risk. When central banks raise rates to fight inflation, the value of existing fixed-rate bonds falls because their locked-in coupons become less attractive. However, the owner of a floating-rate note simply smiles. As the benchmark rate rises, their coupon payments increase, and the security's price tends to remain stable, close to its par value. This makes FRNs a popular safe haven when investors anticipate a period of rising rates.

The flip side is equally true. In a falling-rate environment, the income from a floating-rate asset will decrease with every reset. An investor who locked in a 5% fixed-rate bond will continue to enjoy that 5% yield, while the FRN holder might see their income stream dwindle from 5% to 3% to 1% as the benchmark falls. This makes them less attractive when you expect economic slowing or a dovish central bank policy.

Herein lies the biggest trap for the unwary investor. While your income from an FRN is protected from rising rates, the source of that income is not. The company or entity that issued the bond must now make higher interest payments. For a strong, healthy company, this may be manageable. But for a highly indebted, marginal company—the kind often issuing high-yield leveraged loans—a sharp rise in interest rates can be a dagger. Their interest expense can balloon, eating into cash flow and dramatically increasing the risk of default. A true value investor doesn't just look at the attractive floating-rate feature. They dig deep into the borrower's balance sheet, asking the crucial question: Can this company survive and thrive if its interest payments double? The spread offers compensation for this risk, but a disciplined investor must determine if that compensation is truly adequate for the potential danger ahead.