Floating-Rate Bond Features

A Floating-Rate Bond has a coupon that resets periodically—usually every three to six months—to a benchmark rate (such as SOFR, LIBOR, or the Treasury rate) plus a fixed spread, insulating the bondholder from interest rate risk.

Why floating rates matter in a rising rate environment

In a fixed-rate bond, when interest rates rise, existing bond prices fall because new bonds offer higher coupons. But a floating-rate bond’s coupon rises with rates, so the bond’s par value remains stable. The next coupon payment will be higher, keeping the bondholder’s yield competitive with newly issued bonds. This makes floating-rate bonds ideal for investors who fear rising rates and want protection without selling and taking a loss.

Structure: benchmark plus spread

A floating-rate bond typically pays (for example) “3-month SOFR + 250 basis points.” The SOFR component resets quarterly or semi-annually based on the actual rate; the 250 basis points (2.5%) is fixed for the bond’s life. If SOFR is 5.0%, the coupon is 7.5%; if SOFR rises to 5.5%, the coupon becomes 8.0%. The spread compensates the investor for credit risk, liquidity risk, and the time the bond is outstanding.

The spread is critical. A high-quality corporate bond might float at SOFR + 150 basis points; a junk bond at SOFR + 500 basis points. The wider spread reflects higher default risk. When credit spreads widen (fear increases), the spread embedded in a floating-rate bond does not change—it is locked in—but newly issued floating-rate bonds come with wider spreads, making them riskier relative to the overall market.

Reset dates and accrued interest

Floating-rate bonds typically accrue and pay interest on a quarterly or semi-annual schedule. The reset date (when the benchmark is set) often falls a few days before the payment date, giving time for calculations. An investor who purchases a floating-rate bond between reset dates pays accrued interest to the seller, just as with fixed-rate bonds, but the upcoming coupon is the one that matters most because it will reflect the investor’s hold period.

Price volatility and convexity

Because the coupon adjusts to keep pace with rate changes, floating-rate bond prices are far less volatile than fixed-rate bonds. A fixed-rate bond loses 5–10% of its value when rates spike; a floating-rate bond loses almost nothing because the next coupon compensates. This is the trade-off: low price convexity but immunity from interest rate risk.

However, floating-rate bonds are not risk-free. They carry credit risk—the issuer may default. They also carry reinvestment risk if the investor is counting on a specific return, because the coupon amount is unknown until each reset. And if the benchmark rate falls to zero or negative (as happened in parts of Europe), the coupon can be capped at zero, eliminating income protection.

Benchmarks in transition: LIBOR to SOFR

Historically, LIBOR was the standard floating-rate benchmark. But LIBOR is being phased out globally (fully by 2024 in most currencies) due to manipulation concerns and declining usage. The replacement in US dollars is SOFR (Secured Overnight Financing Rate), which is based on actual transactions in the repurchase market and is harder to manipulate.

Floating-rate bonds issued today use SOFR or other backward-looking benchmarks like the Secured Overnight Financing Rate. Bonds issued years ago may still reference LIBOR and are being transitioned to SOFR via amendment or scheduled maturity. This transition does not typically affect bond holders negatively—the spread adjustment offsets any mechanical difference—but it does require attention during documentation.

Yield and valuation

Because floating-rate bonds reset regularly, their yields are essentially the current SOFR rate (or equivalent) plus the fixed spread. This means floating-rate bonds are less sensitive to yield curve changes than fixed-rate bonds. A floating-rate note trading at par yields the spread—e.g., 250 basis points—regardless of the absolute level of SOFR. An investor comparing a floating-rate bond to a fixed-rate bond must account for this: the floating-rate bond has lower duration and lower interest rate risk, but potentially lower total return if rates stay flat or fall.

Use in portfolios and liability matching

Floating-rate bonds are especially useful for institutional investors (banks, insurers) with floating-rate liabilities or short-term funding needs. A bank with variable-rate mortgages as assets benefits from funding itself with floating-rate bonds—as mortgage rates rise, the bank’s funding costs rise in sync, protecting net interest margin. Pension funds with shorter time horizons also favor floating-rate bonds to avoid bond duration risk.

Retail investors in a rising-rate environment may also hold a small allocation (10–20% of the bond portion) to floating-rate funds or bond ETFs that hold them, as a hedge against inflation and rate increases.