Definition: A bond whose interest rate moves up and down periodically with market interest rates.
Example: DEB Corporation issues bonds whose rate is 3% above the Federal Funds Rate set by the Federal Reserve Bank. Let’s say that this rate is currently 2%. This means that DEB’s bonds will pay 2% + 3%, or 5%. The Federal Funds rate is checked every 90 days so that if it has changed, the rate paid by DEB’s bonds will change accordingly. For example, if the Federal Funds Rate is lowered to 1.5%, the bond’s interest rate will drop to 1.5% + 3%, or 4.5%.
Investeach explains: Floating rate bonds turn our understanding of what bonds are upside down. We initially learn that bonds have a fixed face value and a fixed interest rate. Therefore, the annual interest payment, which is the face value * the interest rate, is also fixed. With a normal bond, when market interest rates change during the life of the bond, it is the bond’s market value that adjusts upward and downward in response.
Not so with floating rate bonds. Because the rate floats, regularly adjusting to current market interest rates, the market value of the bond doesn’t have to. Therefore, it stays near its face value for its whole life.
The rate is calculated in reference to a commonly cited interest rate such as the Federal Funds Rate mentioned above or the London Inter-Bank Offered Rate (LIBOR).
Recognize that a corporation takes a risk issuing these bonds as do bond investors in purchasing them. If interest rates rise, the bond investor wins and the corporation loses. If rates fall, the corporation wins and the bond investor loses.
Finally, consider how difficult a floating rate bond can be to issue and own. The corporation cannot know with any certainty how much interest it will have to pay year-in and year-out over the life of the bond. Similarly, the bond investor cannot know how much interest he or she will receive any given year.
Riddle me this:
1. In what substantial way are floating rate bonds different than conventional bonds?
2. Why does the market value of a floating rate bond remain at or about the face value of the bond over its life?
3. Identify the general method corporations use to determine the floating rate.
4. Why do floating rate bonds make planning for corporations more difficult than conventional bonds do?