Floating-Rate Corporates
Floating-Rate Corporates
A floating-rate corporate bond has a coupon that resets periodically (quarterly, semi-annually) based on a short-term reference rate plus a fixed spread. As interest rates rise, the bond's coupon increases, protecting the bondholder from duration extension and price depreciation. Floating-rate bonds appeal to investors hedging interest-rate risk or betting on rising rates.
Key takeaways
- Floating-rate bonds reset coupons every 3–6 months based on a reference rate (SOFR, prime, LIBOR) plus a fixed spread
- They have minimal duration and price sensitivity to interest-rate changes (price appreciation if rates fall is limited by coupon reset)
- Floating-rate bonds protect against rising rate scenarios; fixed-rate bonds protect against falling rates
- Credit spread is embedded in the fixed spread, making floating-rate bonds comparable to fixed-rate bonds on a yield-to-maturity basis
- Floating-rate corporates are common in bank debt and lower-grade corporate markets; investment-grade companies typically issue fixed-rate bonds
How floating-rate coupons work
A typical floating-rate corporate bond specifies:
Reference rate: The index on which the coupon resets:
- SOFR (Secured Overnight Financing Rate): The overnight federal funds rate secured by Treasury collateral. Replaced LIBOR as the primary rate in 2023. SOFR averages roughly 5% in 2024
- EURIBOR: The euro equivalent of SOFR, used for euro-denominated floating-rate bonds
- PRIME: The prime lending rate published by banks (currently around 8.5% in the US)
- 3-month T-bill rate: Historical reference, less common now
Spread (margin): A fixed percentage added to the reference rate. Example: SOFR + 250 basis points (2.5%)
Reset schedule: How often the coupon resets:
- Quarterly: Every 3 months (most common for SOFR-based notes)
- Semi-annual: Every 6 months
- Annual: Annually (less common)
Reset dates: Specified dates in the indenture (often the 15th of specific months)
Example: A $1,000 par floating-rate bond with "SOFR + 250" and quarterly reset:
- Q1 2024: SOFR = 5.33%, coupon = 5.33% + 2.50% = 7.83%; quarterly coupon payment = $1,000 × 7.83% / 4 ≈ $19.58
- Q2 2024: SOFR = 5.41%, coupon = 5.41% + 2.50% = 7.91%; quarterly payment ≈ $19.78
- Q3 2024: SOFR = 5.50%, coupon = 5.50% + 2.50% = 8.00%; quarterly payment ≈ $20.00
As SOFR changes, coupon payments adjust. The bondholder's income rises or falls with market rates.
Why floating-rate bonds have zero duration
A fixed-rate bond's coupon is locked. If rates rise, the bond's price falls because future coupons (which are now below-market) are worth less when discounted at higher rates. The bondholder is hurt by rising rates.
A floating-rate bond's coupon resets with rates. If rates rise, the next coupon also rises, offsetting the discounting impact. The bondholder receives higher coupons, insulating price from rate changes.
Mathematically, a floating-rate bond trading at par has zero duration: small changes in interest rates produce negligible price changes. A 1% rise in rates raises the coupon but lowers present value by roughly the same amount, leaving the price near par.
This is attractive in a rising-rate environment. An investor holding fixed-rate bonds sees prices fall as rates rise. An investor holding floating-rate bonds sees coupons rise but prices stay near par—a trade-off of lower capital gains for income stability.
Fixed vs. floating: When to use each
Fixed-rate bonds:
- Appropriate when interest rates are expected to fall (capital gains are possible)
- Provide income stability; coupons do not change with rates
- Suitable for investors who want to lock in a rate and cannot tolerate income fluctuation
- Popular in a declining-rate environment (e.g., 2019–2020)
Floating-rate bonds:
- Appropriate when rates are expected to rise
- Provide duration/price stability; rates protect you from capital loss
- Suitable for investors who want income to adjust with market rates
- Popular when the Fed is tightening or rates are at lows and likely to rise
- Also suitable for investors who are uncertain about rate direction and want minimal duration risk
Credit spreads in floating-rate bonds
The fixed spread (SOFR + spread) includes compensation for credit risk. For example:
- AAA-rated bank: SOFR + 150 basis points
- BBB-rated corporate: SOFR + 350 basis points
- High-yield corporate: SOFR + 500+ basis points
The spread reflects the issuer's default probability and recovery rate, similar to fixed-rate bonds. A credit downgrade widens the spread; an upgrade tightens it.
When comparing a floating-rate bond to a fixed-rate bond from the same issuer, the spread should be consistent. If floating-rate yields 7% (SOFR 5.5% + 150 bps) and fixed-rate yields 7% (fixed coupon), they are roughly equivalent—the trade-off is duration risk (fixed-rate falls in price if rates rise; floating-rate doesn't).
Advantages of floating-rate corporate bonds
Duration hedging: For investors with long-duration liabilities (pension funds, insurance companies matching long-term obligations), floating-rate corporates hedge interest-rate risk. Rising rates increase both the coupon income (matching the liability reset) and reduce duration volatility.
Income in rising-rate environment: If you expect or experience rising rates, floating-rate bonds provide increasing income without capital losses.
Minimal price volatility: Floating-rate bonds trade in a narrow range (usually 98–102) because duration is near zero. Price volatility is driven by credit spread changes, not rate changes.
Liquidity: Floating-rate corporates issued by major banks and strong corporate issuers are highly liquid. Dealers maintain tight bid-ask spreads.
Disadvantages of floating-rate corporate bonds
Lower yield in stable or falling-rate environment: If rates stay flat or fall, floating-rate bonds underperform fixed-rate bonds. A floating-rate bond that starts at SOFR + 250 (7.8% in 2024) might fall to SOFR + 250 (6.5%) if SOFR falls—losing 130 basis points of income.
Complexity: Understanding reference rates, spread mechanics, and reset schedules is more complex than evaluating fixed-rate bonds. Investors unfamiliar with floating-rate mechanics may misprice them.
Limited upside in falling-rate scenario: If SOFR falls dramatically (e.g., to 2% in a recession), coupons fall. The bondholder gets lower income and cannot benefit from price appreciation (because floating-rate bonds are called at par by issuers in distress, leaving no upside).
Reinvestment risk in falling-rate environment: If coupons fall due to lower SOFR, reinvestment rates also fall, compounding the impact. The bondholder is unable to reinvest at the original high rates.
Floating-rate bank loans vs. floating-rate bonds
Floating-rate corporate bonds are distinct from floating-rate bank loans, which are also common in credit markets:
Floating-rate bonds:
- Issued in securities form; publicly traded (or held by institutional investors in the secondary market)
- Covenants are moderate; more standardized terms
- Issued by a mix of corporate issuers (not just banks)
- Rating agencies provide ratings
- Useful for investors seeking diversified credit exposure
Floating-rate bank loans:
- Issued directly by banks; held in syndicated loan pools
- Covenants are typically stricter (lenders are more aggressive in monitoring)
- Issued primarily by middle-market and lower-market corporates
- No rating; credit assessment by lenders and loan funds
- Senior to bonds (typically unsecured bonds rank behind secured bank loans)
- Higher recovery rates in default (secured by assets or cash flow)
Many loan funds (CLOs—collateralized loan obligations) securitize floating-rate loans, creating tradeable securities. For individual investors, loan funds provide floating-rate exposure without need to analyze individual loans.
Examples of floating-rate corporate bonds
JPMorgan Chase 5.25% + SOFR Notes due 2028 (issued 2023):
- Structure: SOFR + 525 basis points (with a 5.25% floor)
- The floor protects the bank if SOFR falls below 5.25%; the coupon is capped and does not decline below 5.25% even if SOFR falls dramatically
- Used by JPMorgan to fund balance sheet in a rising-rate environment; the floating coupon matches the bank's floating-rate assets
Bank of America Floating-Rate Notes (various tranches):
- Typically issued as SOFR + 200–300 basis points (depending on maturity and subordination)
- Used by institutional investors seeking short-duration credit exposure
- High liquidity; tight spreads in the secondary market
Leveraged-finance floating-rate bonds:
- Issued by private-equity backed companies, often as "PIK toggle" bonds (toggle between cash and payment-in-kind)
- SOFR + 500+ basis points
- Riskier issuers warrant higher spreads to compensate for credit risk
Interest-rate scenario analysis: Fixed vs. floating
Scenario 1: Rates rise from 5% to 7%
- Fixed-rate bond (5% coupon): Price falls to $950 (duration loss outweighs coupon income)
- Floating-rate bond (SOFR + 250): Coupon rises to 7.5%; price stays near par
- Winner: Floating-rate bond
Scenario 2: Rates fall from 5% to 3%
- Fixed-rate bond (5% coupon): Price rises to $1,050 (capital gains exceed coupon opportunity loss)
- Floating-rate bond (SOFR + 250): Coupon falls to 3.5%; price stays near par, misses capital gains
- Winner: Fixed-rate bond
Scenario 3: Rates stay flat at 5%
- Fixed-rate bond: Stays at par, collects steady 5% coupons
- Floating-rate bond: Stays near par, coupons fluctuate around SOFR + 250
- Winner: Roughly tied
Decision tree: Fixed vs. floating-rate bonds
Next
Floating-rate bonds are typically issued in the bank and leveraged-finance space. Medium-term notes, another structure, allow issuers to access capital on a flexible timeline by continuously offering new notes from a shelf prospectus.