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What Are Floating Rate Bonds?

Ray Hawk
Ray Hawk

Floating rate bonds are a type of investment security that pays a percentage of the principal value that is usually based on the changing nature of interest rates. While, on the surface, these types of securities may seem more risky to invest in than bonds with a guaranteed percentage return, they are actually more secure as they cannot lose value as precipitously as a bond whose fixed rate of return is outpaced by increases in inflation. Floating rate bonds can be part of a collection of securities that are invested in as a single unit, such as components of mutual funds or index funds, and they are often referred to as floating rate notes (FRNs) or just floaters.

While floating rate bonds can be more secure than their fixed rate alternative, they also have the downside of generally offering less positive returns on investment due to the fact that, when interest rates are low, they also yield a low rate of return. The adjustment rate for how the bond is tied to interest rates is also not automatic and may only be reset once or twice a year, which can add volatility to the bond in an economic environment where interest rates are changing rapidly as they did in the 1970s. This makes these types of floating exchange rate investments similar to other financial tools such as debts like the floating mortgage rate or adjustable rate mortgage (ARM), though ARMs are usually reset every month based on current interest rates.

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Floating rate loans are another type of debt based financial instrument that also fluctuates based on interest rate changes. Investors in floating rate loans benefit when the market is displaying a rapid rise in interest rates as do investors in floating rate bonds. While this is more expensive for the borrower, floating rate loans are often a financial vehicle of choice for companies that need to raise a lot of cash quickly to orchestrate leveraged buyouts of competitors. A floating rate loan is usually set to interest rates on a quarterly basis unlike floating rate bonds, and the percentage yield is a fixed number of points above the London Interbank Offered Rate (LIBOR). LIBOR is an international banking standard for interest rates set daily in the UK by the British Bankers' Association (BBA).

Investing in financial assets that fluctuate based on the exchange rate system and rising interest rates can be beneficial in the short term, but it tends to cause a feedback loop that can result in a speculative bubble. In early 2011, record amounts of cash poured into floating rate investments worldwide with over $10,000,000,000 US Dollars (USD) in new investment capital entering the floating rate market as of the end of February 2011. This also resulted in higher expenses for borrowers of floating rate loans as investment firms raised the yield the investments offered to attract new clientele by March 2011. The trend also resulted in banks lowering their standards for whom they will loan money to, with floating rate loans raising speculation in the market to values not seen since 2007. Once such speculation reaches a certain peak, it can decline rapidly and cause massive investor losses, since floating rate bonds and loans are much less of a liquid form of equity easily disposed of as compared to stocks in the traditional market.

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