Floating rate debt securities are securities that are structured with a variable or floating rate of interest that is determined based on the current average interest rates that apply in the jurisdiction where the securities are sold. Debt securities of this type may include several different types of investments, such as bond issues, promissory notes, or even mortgages and other loans. Like any debt security, each of these will be structured with a maturity or due date, with specific terms related to the repayment of the security.
One of the easiest ways to understand how floating rate debt securities function is to consider floating rate bonds. Bonds of this type will pay a rate of interest that is based on the current rate of interest at the time an interest payment becomes due. Typically, the arrangement will include what is known as a floor rate, meaning that even if the average interest rate drops below that floor, the investor still gets at least that minimum rate. With a bond issue that issues periodic interest payments several times throughout the life of the bond, the amount of interest paid could vary each time, based on what is happening with interest rates in general. The hope of the investor is that the average interest rate increases from one period to the next, effectively increasing the return on the investment.
Another example of floating rate debt securities is the floating home loan. A loan of this type will be configured with a variable or floating mortgage rate that will change based on the current average rate. A mortgage of this type will usually guarantee a fixed rate for a specified number of years at the beginning of the loan, then switch to the floating or variable rate for the remainder of the mortgage. Floating rate debt securities with this type of arrangement can be very good for homebuyers if there is a reasonable chance that the average rate will be relatively low for the majority of the mortgage term.
Typically, floating rate debt securities will include provisions that protect both parties in the agreement. This is because the terms of the agreement usually include both a floor and a ceiling for the amount of interest that may be assessed. This means that a homeowner with a variable interest rate mortgage will only pay so much, even if the average interest rate should increase significantly. At the same time, the mortgage lender is protected because even if average mortgage rates drop to record lows, the floor rate named in the contract ensures at least a certain amount of return from the loan.