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What Is Floating Rate Debt?

Jim B.
Jim B.

Floating rate debt is any type of debt that is issued with interest rates that may change based on some interest rate benchmark. As opposed to those debt issuances with fixed interest rates, the rates in these cases may float depending upon how prevailing market rates are faring. One major type of floating rate debt is a floating rate bond, which protects investors from rising interest rates devaluing the bonds that they already own. Another type is an adjustable-rate mortgage, which allows homeowners to benefit if interest rates on mortgages are falling.

Any type of debt instrument in the world of finance, whether it's a credit card, a mortgage, or a bond, is accompanied by interest rates. Interest rates are the way in which the lenders in a debt agreement are compensated for taking on the risk that the borrowers might default on their payback obligations. The interest rates attached to various debt instruments tend to fluctuate based on some sort of circumstances in the market or industry in question. Floating rate debt allows those in the midst of debt obligations some protection should interest rates change.

Man climbing a rope
Man climbing a rope

As an example of how floating rate debt works, imagine someone who owns a bond paying back a fixed interest rate. Should market interest rates rise while he or she is holding the bond, the value of that bond will drop. This is because investors can get much more favorable deals on the bond market where the higher interest rates are prevalent. If the investor tries to sell the bond, he or she would likely have to do so at a discount to compensate for the non-competitive interest rates attached.

With floating rate debt, the investor would be protected in this case. The bond's interest rate would be adjusted on a semi-regular basis to account for any changing market rates. As a result, the bond stays competitive with other bonds in the market, and the value of the principal owed to the investor will likely stay at or near its original level.

This is the same type of process used for an adjustable rate mortgage, another type of floating rate debt that benefits homeowners. In this case, the homeowner is the borrower, and the value of the mortgage would suffer if home interest rates were dropping. With an adjustable-rate mortgage, the interest rates on the mortgage are adjusted throughout the life of the mortgage, depending on the terms agreed upon at the outset of the home purchase.

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