Definition of a Floating-Rate Bond

by Tim Plaehn, Demand Media Google
    Floating rate-bonds pay attractive yields in a low rate environment.

    Floating rate-bonds pay attractive yields in a low rate environment.

    In your search for better investment yields, you will come across a wide range of types of interest-paying securities including floating-rate bonds. During periods of low interest rates, these bonds can provide a better current yield and some protection against rising rates. You must understand the potential risks before jumping into a floating-rate bond investment.

    Fixed vs. Floating Rates

    The majority of investment bonds and notes are issued with a fixed rate of interest payment. If you purchase a regular corporate bond, the bond will pay the same amount of interest semi-annually until the bond matures and the principal is repaid. A floating-rate bond or floating-rate note pays interest that changes with changing investment market interest rates. The interest rate for a floating-rate note is calculated using an index rate plus an interest spread. To introduce a little bond investing jargon, market participants use the term "basis point" to indicate 1/100 of a percent. For example, if a floating-rate note pays an index rate plus 250 basis points, the rate paid is the current rate of the index plus 2.5 percent..

    The Floating Rate Market

    The primary issuers of floating-rate bonds are corporations which issue the bonds as a way to borrow money. Using a floating-rate issue allows a corporation to borrow for a longer term without paying long-term interest rates. Floating-rate securities are issued with a wide range of maturities, interest rate periods, spreads and other features. Corporations with lower, non-investment grade credit ratings are more likely to issue floating-rate notes. The interest rates paid on floating-rate securities can be significantly higher than for short-term securities, which are often the alternative investment choice.

    Benefits of Floating Rate Securities

    The most obvious benefit to floating-rate bonds is the ability to earn a higher rate of interest than the current market rates for certificates of deposit or short-term government securities. The floating-rate feature protects both the investment's market value and your purchasing power if interest rates start to increase. With fixed-rate bonds, rising rates result in falling bond prices. With floating-rate investments, the interest rate earned will increase right along with the market rates. Floating-rate securities are a good investment choice if you think rates will rise in the future.

    Investment Considerations

    It would be difficult for an individual investor to adequately assess the investment potential and risks of an individual floating-rate bond. Too many variables are involved. The best avenues for floating-rate investments are through managed investment products. Investment companies offer mutual funds, closed-end funds and exchange traded funds -- ETFs -- that invest in floating-rate debt securities. ETF and closed-end fund shares are purchased through an brokerage account. Mutual fund shares can be bought using a broker or going directly to the mutual fund company.

    About the Author

    Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.

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