How to Estimate the Yield on Floating Interest Rate Bonds

How to Estimate the Yield on Floating Interest Rate Bonds

How to Estimate the Yield on Floating Interest Rate Bonds

Floating rate bonds, sometimes referred to as floaters, differ from standard bonds in that the interest rate, or yield, paid out to the investor fluctuates. The yield is based on one of a number of interest rate indices, such as the federal funds rate or Treasury Bill rates. This can make estimating a yield to maturity difficult because to do so, you must make certain assumptions about the rate on which the floater’s yield is based.

Collect the Data

Estimating the yield of a floater requires a number of key pieces of data. First, you must find out the maturity term of the bond. This is the length of time between the date on which you purchase the bond and the date on which it expires. For floaters, this is generally five years. Finally, you need the interest spread, which is the percentage amount above or below the index the bond is tied to that will be added or subtracted from your yield.

Estimate Index Rate

Because your yield is tied to an interest rate index, you need to try and predict the behavior of that index between the present time and the maturity date of your bond. You can do this in a number of ways. The first method is to conduct your own analysis and form your own conclusions. To do this, you will need to form an opinion on how you think the economy will grow during the term of your bond. In general, as an economy expands, interest rates rise, and vice versa. Therefore, if economic growth is slow, you might conclude the interest rate index your yield is based on will rise in the future. Alternatively, you can consult the financial media. Type “interest rate forecast” into your favorite search engine and browse through the results. There is no shortage of industry analysts willing to share their opinion online. Finally, if your bond’s yield is tied to the federal funds rate, you can consult the Federal Open Market Committee statement. Each month, the 17 members of the FOMC release their forecast for the federal funds rate.

Calculate Your Yield

Add or subtract the interest spread from your average predicted index rate to get your return rate. For example, imagine your floater tracks the federal funds rate, and you assume the rate will average out to 4 percent over the next five years. Now imagine your spread is 1.5 percent. Add 1.5 percent to the 4 percent, to get 5.5 percent. Your estimated yield is 5.5 percent.

Just an Estimate

Calculating your yield in this way will only give you an estimate. The economy is unpredictable. and accurately forecasting its behavior — and this behavior might affect interest rates — can be difficult, so don't expect to produce exact yield predictions.

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About the Author

Samuel Rae is an experienced finance journalist whose work has been published across a range of different sites and publications in the financial space including but not limited to Seeking Alpha, Benzinga, iNewp, Trefis and Small Cap Network. He holds a BSc degree in economics.