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Meaning and Definition
Inverse floating rate bonds, more commonly known as inverse floaters, are actually opposite to traditional floating rate bonds or floaters. In order to understand inverse floaters, it is important to understand floating rate bonds.
Floating rate bond or floaters are bonds that have coupon payments that reset periodically according to some reference rate such as LIBOR, 5-year Treasury Yield, etc. There are two components of coupon rates i.e. reference rate & fixed rate (margin). In floaters, the coupon rates have direct relation to reference rates i.e. coupon rates go in the same direction as the reference rate, for example, if reference rate increases, the coupon rate will also increase & vice versa.
As opposed to floaters, inverse floaters are bonds whose coupon rate moves in the opposite direction from the change in reference rate. Again the reference rate may be LIBOR, EURIBOR, US Treasury Rates, etc. This means that if reference rate increases, coupon rate will decrease & vise versa.
How does Inverse Floater Works?
Working of an inverse floater is quite straightforward. On every coupon reset date, the coupon rate is calculated by subtracting reference interest rate from a constant. So its formula looks like following:
Coupon Formula for Inverse Floater
Coupon Rate = Fixed rate K – (Coupon Leverage L x Reference Rate R) = K – (L x R)
Example with Calculation
Fixed Rate = 20%,
Coupon Leverage = 2 &
Reference Rate = 3-month Treasury bill rate
Coupon Rate = 20% – (2 x 3 month treasury bill rate)
Now suppose we want to calculate coupon rate as on March 5, 2018
3-month treasury bill rate as on March 5, 2018 = 1.67%
Therefore Coupon Rate = 20% – (2 x 1.67%) = 20% – 3.34% = 13.66%
From the formula, we can come to the conclusion that, when the reference rate goes up, the coupon rate will go down given the reference rate is deducted from the coupon payment. Similarly, as reference rates fall, the coupon rate increases because less is taken off.
In the above example, notice that if 3-month Treasury bill rate exceeds 10%, then the coupon formula would produce a negative coupon rate. To prevent this there is a floor imposed on coupon rate, i.e. coupon rate cannot fall below its floor rate. Furthermore, the inverse floater also comes with an inherent cap, i.e. if the reference rate becomes zero, the fixed rate becomes the cap rate. In the above example, the cap rate is 20%.
Why Invest in Inverse Floaters?
There are mainly two reasons for which investors invest in inverse floaters:
Higher Interest Rates
For those investors who believe that interest rates will decline in future, inverse floaters give them the opportunity to earn higher interest rates. This can also prove to be a diversification opportunity for any portfolio.
Inverse floaters can also act as a tool for investors who wants to hedge against the risk of falling interest rates. If an investor has invested in regular bonds, and if the interest rate falls, then they will receive lower returns than expected. In this scenario, it is extremely helpful to have inverse floaters in the portfolio as it gives higher returns when interest rates fall.1