Floating Rate Notes
Floating rate notes are also known as Floater. A Floater is a kind of a bond or a debt instrument which a variable coupon rate, which can also be term as “interest rate”, which is decided on the basis of the benchmark rates such as the U.S. Treasury note rate and London Interbank Offered Rate (LIBOR), also known as Federal Reserve funds rate. The rate can be adjusted monthly or, quarterly on the basis of these benchmark rates. These instruments are issued by financial institutions, governments, and other corporate bodies.
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How does it work?
The floater can also be considered as a fixed-income bond because when an investor purchase such a bond for two years of maturity, let’s say for example the face value of this note is Rs.1000 with 3 months of reference rate on the basis of LIBOR rate plus 0.5%, and if the 3 month LIBOR rate is 0.55% then you will earn 1.5% (i.e. 0.5% + 0.55%) for the first 3 months. Now for the next 3 months, the LIBOR rate is 0.88%, hence for the next 3 months you can earn an interest of 1.38% (i.e. 0.5% + 0.88%) and likewise the interest is paid for the next two year as of our maturity period. There are two terms use in Floating Rate Notes i.e. Cap and Floor. Cap helps the issuer by placing a limit on how high the coupon rate can raise if the coupon rate rises above the cap rate then it is applied within the cap rate decided. The floor helps the investor by placing a minimum on the coupon rate if the LIBOR or any rate which is considered to be the reference rate for the notes falls below then the floor rate, then also the investor may get the rate as decided by the floor.
Types of Floating Rate Notes:
Plain Floating Rate Note: In this type of note, the rate of interest on your note mainly depends on the change in market i.e. money market or capital market. If the market rate rises the interest to earn also rises and if the market rate falls the return on for investment also reduces.
Capped Floating Rate Note: As cap helps the issuer by placing a limit on how high the coupon rate can raise, if the coupon rate rises above the cap rate then the investor will receive the amount as decide on the cap rate. This type of note is called the Capped Floating Rate Note.
Floored Floating Rate Note: Floor Floating Rate Note help the investor by placing a minimum on the coupon rate, if the coupon rate falls below then the floor rate, then also the investor may get the rate as decided by the note’s seller.
Collared Floating Rate Note: This type of note holds the combination of both floored and capped notes. Collared Floating Rate Note offers both minimum and maximum coupon rates to limit the return to the investor and risk to the issuer through a specified range of interest rates.
Perpetual Floating Rate Note: In this type of note, the maturity date is not fixed. Investors can the income constantly and in perpetuity. This type of note is basically considered as a long term investment.
Reverse Floating Rate Note: As the name suggests it works in a reverse way than that of the regular Floating Rate Notes. In this type of note, all the structure and function are the same as regular Floating Rate Note but the computation of the rate is estimated inversely. So, we can consider that an investor can also receive huge profits from declining rates.
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Benefits of investing in Floating Rate Notes
- The main benefit that any investor can enjoy through this floating rate note is, they can receive the benefit of a higher coupon rate.
- There is a various option available with an investor to invest in a particular type of note to secure his investment and to gain a high return from it.
- Governments, financial institutions, corporate issues such instruments so according to that, an investor can invest in it.
Risks of investing in Floating Rate Notes
- The risk in investing in any financial institution notes or any corporate notes is riskier but on the other hand, the return for such note is also very high.
- And the risk associated with government notes is comparatively lower than other institutions but on the same side return is also less.
Author: Charmi Mehta
About the Author: Charmi Mehta is currently pursuing an MBA with a specialization in Finance from the Department of Business Administration, Bhavnagar. Charmi is very much interested to work with data and its analysis and she is also fascinated by the financial market.