Floating Price

A Floating Price is a price for a product, service, or financial instrument that is not fixed but instead fluctuates over time based on an underlying benchmark rate or market index. Think of it as a price that “floats” on the waves of a specific market. This is the opposite of a fixed price, which, as the name suggests, is locked in and doesn't change regardless of market conditions. Floating prices are incredibly common in the world of finance, particularly for instruments like bonds, loans, and derivatives. The goal is to create a price that automatically adjusts to new economic realities, especially changes in interest rates. This dynamic nature can be a double-edged sword, offering protection in some scenarios while introducing uncertainty in others. For an investor, understanding whether the price of an asset they own is floating or fixed is fundamental to assessing its potential risks and rewards.

At its heart, a floating price isn't random; it's calculated using a simple, transparent formula. This predictability in how it changes is what makes it a useful tool.

Most floating prices, especially for financial products like loans or bonds, are made up of two key parts:

• The Benchmark: This is the “floating” part. It’s a widely recognized, independent reference rate that reflects general market conditions. Think of it as the base cost of money at a given time. Common benchmarks include:
  • SOFR (Secured Overnight Financing Rate) in the U.S.
  • EURIBOR (Euro Interbank Offered Rate) in the Eurozone.
  • Historically, LIBOR was the global standard, but it has been largely phased out.
• The Spread: This is a fixed percentage added to the benchmark. The spread, also called the margin, typically represents the additional risk the lender or investor is taking on. For example, a company with a shaky financial history will have to pay a wider spread on its debt than a rock-solid blue-chip company, as it reflects a higher credit risk.

The formula is straightforward: Floating Price/Rate = Benchmark Rate + Spread

Imagine you're a value investor looking for a safe place to park some cash, and you buy a floating-rate note (FRN) from a company called “Stable Co.” The terms are:

• Benchmark: SOFR
• Spread: 1.5%
• Interest Payments: Quarterly

If, at the start of a quarter, the SOFR is 3.0%, the interest rate you'll receive for that quarter will be 3.0% + 1.5% = 4.5% (annualized). Now, let's say the central bank raises interest rates to combat inflation. In the next quarter, SOFR jumps to 4.0%. Your interest payment automatically adjusts. The new rate you receive is 4.0% + 1.5% = 5.5%. Your income from the bond has floated upwards with the market, protecting your purchasing power.

For a value investor, understanding the pricing mechanism of an asset is non-negotiable. It's about knowing what you own. A floating price introduces a unique set of considerations that tie directly into core value investing principles.

The biggest advantage of owning a floating-price asset is its built-in defense against rising interest rates. When you buy a traditional fixed-rate bond and rates go up, your bond becomes less attractive, and its market price falls. But with a floating-rate bond, your income stream adjusts upwards, helping the bond's value hold up much better. This can be a form of margin of safety against interest rate risk, a major concern for bond investors. In an inflationary environment where central banks are likely to raise rates, floating-price debt can be a savvy move.

Naturally, what goes up can also come down. If interest rates fall, the income from your floating-price asset will also decrease. This introduces uncertainty into your future cash flows. A value investor who relies on predictable income to value a business or a security might find this unpredictability unappealing. If you believe rates are headed lower, a fixed-price asset would be a better choice, as it would lock in a higher payment.

Floating-price instruments can sometimes come with sneaky fine print. Be on the lookout for:

• Caps: A maximum rate the instrument can pay. A cap can limit your upside if rates skyrocket.
• Floors: A minimum rate the instrument will pay. A floor protects you if rates plummet, making the asset more attractive.
• Benchmark Risk: What happens if the benchmark itself becomes unreliable? The transition away from LIBOR showed that the very foundation of a floating price can change, introducing unexpected risks.

Let’s boil it down to a simple comparison.

• Predictability
  1. Fixed: High. You know exactly what your income will be.
  2. Floating: Low. Your income will change over time.
• Performance in Rising Rates
  1. Fixed: Poor. The value of your asset typically falls.
  2. Floating: Good. Your income increases, helping to preserve the asset's value.
• Performance in Falling Rates
  1. Fixed: Good. You've locked in a higher rate, and your asset's value may rise.
  2. Floating: Poor. Your income will decrease.
• Investor's Best Friend When…
  1. Fixed: You want certainty and believe rates will stay flat or fall.
  2. Floating: You want protection from inflation and believe rates will rise.