Floating rate debt

Floating-rate debt has become a popular option for investors looking to reduce interest rate risk in the fixed-income investment sector. Unlike typical fixed-rate bonds, floating-rate debt has a variable interest rate that fluctuates regularly in accordance with a benchmark index.

What is floating rate debt?

Floating-rate debt, also known as variable-rate debt, is a bond or loan in which the interest rate changes periodically. In contrast, fixed-rate debt has an interest rate that remains consistent throughout the bond’s life. Floating-rate debt is intended to offer investors a hedge against rising interest rates, as interest payments fluctuate according to market conditions.

Understanding floating rate debt

Floating-rate debt is designed to shield investors from rising interest rates. When interest rates rise, the value of interest payments on fixed-rate bonds falls as new bonds with higher yields become more appealing. However, with floating-rate debt, the interest rate moves upward, reducing the influence of rising rates on the bond’s value.

Types of floating rate debt

There are several types of floating-rate debt instruments available to investors:

Floating-to-fixed rate bonds
These bonds initially have a variable interest rate fixed on a specified date. They are suitable for investors anticipating a fall in interest rates since they guarantee a greater fixed interest rate for a specific time. This kind of bond offers investors a sense of security when interest rates are expected to decline.

Inverse floating-rate bonds
These bonds’ interest rates shift opposite to the benchmark rate. The bond rate decreases when the benchmark rate grows, and vice versa. Investors anticipating a reduction in interest rates may find these bonds captivating, as they may give more significant profits in such cases. This bond is appropriate for investors who expect a decrease in interest rates.

Step-up callable bonds
These bonds have a fixed rate schedule that grows over time. The issuers can purchase back these bonds on dates, which frequently coincide with the step-up dates. Rising interest rates benefit investors but also introduce call risk if the issuer chooses to redeem the bonds early. These bonds provide investors with the opportunity for more significant profits, but they also carry the danger of early redemption.

Perpetual floating-rate bonds
These bonds have no expiration date; thus, they will continue to pay interest. The rate is often adjusted depending on a benchmark rate. They may appeal to investors looking for a consistent income stream but carry more credit risk and price volatility than bonds with a fixed expiration date. This form of bond generates long-term income but has a higher risk.

Benefits of floating rate debt

The primary advantage of variable rate bonds is their capacity to hedge against interest rate fluctuations. These bonds’ interest distributions climb with an increase in interest rates, protecting investors from missing out on any profits.

Additional advantages of floating rate debt to investors include the following:

Interest rate protection
Floating rate debt provides a hedge against rising interest rates, as the interest payments adjust upward in line with market conditions.

Diversification
Floating rate debt can help diversify a fixed-income portfolio, as it offers a different risk/return profile compared to traditional fixed-rate bonds.

Potential for higher yields
In some cases, floating-rate debt may offer higher yields than fixed-rate bonds, particularly when interest rates are expected to rise,

Market-linked returns
These bonds’ returns are in line with the prevailing rates in the market. This alignment can be advantageous in a robust economic atmosphere with rising interest rates as it guarantees investors a share of the broader market benefits.

Examples of floating rate debt

The iShares floating rate bond ETF (FLOT)
This exchange-traded fund (ETF) seeks to track the investment results of an index composed of US dollar-denominated, investment-grade floating-rate bonds.
Adjustable-rate mortgages (ARMs)
ARMs are popular in the US housing market, where homebuyers can take advantage of lower initial interest rates compared to fixed-rate mortgages.
Floating Rate Loans
Many companies use floating-rate loans to finance their operations, particularly when interest rates are expected to rise. These loans are often packaged into collateralised loan obligations (CLOs) and sold to investors.

Frequently Asked Questions

How do floating rate debt instruments work?

The interest rates on floating rate debt instruments are modified periodically per benchmark index, like the US Prime Rate or LIBOR. Usually, the interest rate is established as a spread over the benchmark index to safeguard investors from interest rate increases. Examples include floating-rate bonds, loans, and adjustable-rate mortgages (ARMs).

What are the advantages of investing in floating-rate debt?

Investing in floating-rate debt has the following advantages:

The impact of interest rate swings is mitigated by floating rate bonds, which adapt to market interest rates.
Floating-rate debt has the potential to yield more significant returns than fixed-rate debt in a situation when interest rates are rising.
Floating rate debt offers flexibility in managing interest rate risk and can be structured to suit individual investor needs.

What are the risks associated with floating rate debt?

The main risks associated with floating rate debt in the US and Singapore are:

Rising interest rates expose investors to the risk of higher debt servicing expenses.
If interest rates climb dramatically, borrowers may encounter challenges when trying to refinance their loans.
If benchmark rates rise, homeowners with floating-rate mortgages may see an increase in their monthly payments.

How are interest rates determined in floating-rate debt instruments?

Interest rates on debt instruments with floating rates are set by a benchmark index, such as SORA or LIBOR, which is subject to periodic adjustments based on market conditions. The interest rate is usually fixed as a spread over the benchmark index to protect investors from market swings.

How do investors evaluate the performance of floating-rate debt investments?

Investors evaluate the overall performance of floating-rate debt investments by considering the issuer’s creditworthiness, market circumstances, and interest rate fluctuations. In addition to evaluating the fund’s terms, liquidity, and credit quality, they also evaluate the difference between the floating and benchmark rates.