How to Invest in Floating Rate Notes

by Bryan Keythman

A floating-rate note, or “floater,” is a type of bond that makes periodic interest payments that are based on a variable interest rate. A floater’s interest payments increase when interest rates rise and decrease when interest rates decline. Various entities, such as corporations and government agencies, issue this type of bond. There are different ways you can invest in floaters, such as by purchasing individual bonds or buying a bond fund.

Face Value

A floater’s face value is the amount the bond issuer repays when the bond matures. A floater’s market price may differ from its face value based on market interest rate fluctuations or supply and demand. If its market price is higher than its face value, it sells for a premium. If a floater’s market price is lower than its face value, it sells for a discount. For example, if a floater has a $1,000 face value and a $990 market price, it sells for a discount.

Floating Interest Rate

A floater pays and resets its interest payments periodically, such as semiannually. The annual interest rate on which the payment is based typically equals an index plus a margin, which is a fixed percentage set by the issuer. An index is a market interest rate, such as the prime rate, that is used as a reference. For example, if a floater’s margin is 1 percent and the index is 6 percent when its payment resets, its payment would be based on a 7 percent annual interest rate.

Investment Options

You may invest in floating-rate notes individually or through a fund, such as an exchange-traded fund. You may buy each of these options through an investment broker or dealer, who may charge fees or commissions. If you buy floaters individually, you may select particular bonds that pay interest on a schedule that fits your needs. A fund typically charges an annual management fee, but provides a partial stake in a portfolio of bonds that is professionally selected and managed. A fund pays interest based on the bonds it holds.

Credit Rating

Always check a floater’s credit rating or the ratings of the floaters in a fund before making an investment. A credit rating gauges the issuer’s ability to pay interest and repay the bond. Ratings generally range from a high of AAA to a low of D. A floater with a higher credit rating generally has lower risk than one with a lower rating and is more likely to pay interest on time and repay its face value.

Additional Considerations

Unlike fixed-rate bonds, a floater may pay you a different amount of interest with each payment. To limit fluctuations, the interest rate of a floater may be restricted to a maximum and minimum rate, called a “cap” and a “floor,” respectively. This limits your risk if interest rates drop significantly, but may also limit your potential to gain from a large increase in rates. For example, if a floater has a 10 percent cap and interest rates rise to 15 percent, it would pay interest based on only a 10 percent rate.

Photo Credits

  • Jupiterimages/ Images