Floating-Rate Bond

A Floating-Rate Bond (also known as a 'Floater' or Floating-Rate Note) is a type of bond where the interest payment isn't fixed for the life of the loan. Instead, its coupon rate periodically adjusts based on the movements of a benchmark interest rate. Think of it as a financial chameleon, changing its color (its payout) to match its surroundings (the current rate environment). This is the polar opposite of its more common cousin, the fixed-rate bond, which pays the same interest amount year after year, rain or shine. For investors, this floating feature is the bond's superpower: it offers a shield against the wealth-eroding effects of rising interest rates. When benchmark rates climb, the floater’s income payment climbs with them, helping to keep the bond's market price relatively stable. This stability makes it a fascinating tool, especially for conservative investors who prioritize capital preservation.

The magic of a floater isn't really magic at all; it's simple arithmetic. The interest you receive is calculated by taking a well-known, variable benchmark rate and adding a fixed extra percentage on top.

The coupon payment for a floating-rate bond is determined by this straightforward equation: Coupon Rate = Benchmark Rate + Spread Let's break down the two key ingredients:

• The Benchmark Rate: This is the 'floating' part of the equation. It's a reference interest rate that changes with market conditions. The benchmark used depends on the bond's currency and market. Common examples include SOFR (Secured Overnight Financing Rate) for U.S. dollar bonds or EURIBOR (Euro Interbank Offered Rate) for euro-denominated bonds. The bond's prospectus will specify which benchmark it uses and how often the rate “resets”—typically every three, six, or twelve months. When the reset date arrives, the bond's coupon adjusts to the new benchmark level.
• The Spread: This is the 'fixed' part of the deal. It’s a predetermined number of percentage points (also called basis points) added to the benchmark rate. The spread is your reward for taking on the issuer's credit risk—the risk that the borrower might not be able to pay you back. A financially solid, blue-chip company will have a small spread, while a riskier company (issuing what might be considered a junk bond) will have to offer a much larger spread to attract investors. This spread does not change over the life of the bond.

Imagine you buy a floater from Acme Corp. It uses the 3-month SOFR as its benchmark and has a spread of 1.50%.

• If the 3-month SOFR is currently 3.50%, your bond's annual interest rate will be 3.50% + 1.50% = 5.00%.
• Three months later, at the next reset date, imagine the Federal Reserve has raised rates and SOFR has jumped to 4.25%.
• Your bond's interest rate automatically adjusts to 4.25% + 1.50% = 5.75% for the next three months. Your income has gone up without you having to do a thing!

For followers of value investing, floaters aren't just a clever financial product; they are a strategic tool for managing a specific, dangerous risk.

The arch-nemesis of a fixed-rate bond is interest rate risk. When market rates rise, newly issued bonds offer more attractive coupons. This makes existing bonds with lower, fixed coupons less desirable, causing their market price to fall. Floaters neatly sidestep this problem. Because their coupon income rises with market rates, they remain perpetually “current” and their prices tend to hug their par value much more closely. In technical terms, they have a very low duration, which is the primary measure of a bond's sensitivity to interest rate changes. This price stability is a powerful way to protect your principal in a rising-rate world, a goal that would make Benjamin Graham nod in approval.

While floaters are great at fighting interest rate risk, they are not risk-free. A savvy investor must always look for the catch.

• Credit Risk is King: The biggest danger is that the company or government that issued the bond gets into financial trouble and can't make its payments. If the issuer's creditworthiness declines, the price of your bond will fall, regardless of what interest rates are doing. The initial spread is meant to compensate you for this risk, but a potential default can wipe out your investment. Always do your homework on the borrower!
• Caps and Floors: Some floaters come with interest rate caps (the maximum rate the bond will ever pay) or floors (the minimum rate). A cap can limit your potential income if rates skyrocket, so always check the fine print.
• Liquidity Risk: Some floaters, especially those issued by smaller or less well-known entities, can be illiquid. This means you might have trouble selling the bond quickly without accepting a lower price.

So, which one is right for you? It depends entirely on your view of the future and your investment goals.

• Floating-Rate Bonds
  1. Best For: Investors who expect interest rates to rise or stay volatile.
  2. Main Goal: Principal stability and an income stream that adjusts to inflation and monetary policy.
  3. Primary Risk: Credit Risk.
• Fixed-Rate Bonds
  1. Best For: Investors who expect interest rates to fall or remain stable.
  2. Main Goal: Locking in a predictable, unchanging income stream for a set period.
  3. Primary Risk: Interest Rate Risk.

Floating-rate bonds are a valuable instrument in an investor's toolkit, offering an elegant solution to the problem of rising interest rates. They can act as a stabilizing anchor in your portfolio, providing a variable income stream that helps protect the bond's principal value. However, their greatest strength is also a reminder of their most important risk. Because interest rate risk is largely taken off the table, your focus must shift almost entirely to the creditworthiness of the issuer. A floater from a shaky company is a risky bet, no matter how high rates go. A true value investor knows that the ultimate margin of safety comes not from a clever bond structure, but from lending money to an entity that can reliably pay it back.