Floating-rate notes, debt securities with interest rates that typically change at predetermined intervals, appeal to investors as a hedge in times when they expect short-term interest rates to rise. There are several ways you can invest in floating-rate notes, and weighing the various options can help you decide what works best for your financial situation and risk tolerance. Younger investors generally can handle higher risks than older ones, as you have more time to recoup any losses.
Floater Benchmarks and Rates
Floating-rate notes, called simply "floaters" or FRNs by investors, are bonds with a variable coupon or interest rate. Interest earnings on floating-rate notes are tied to a benchmark such as the London Interbank Offer Rate. The LIBOR is an interest rate published by the British Bankers Association and reflects the rate banks require of other banks for loans. Some floating-rate notes use the federal funds rate, the interest rate banks charge each other for overnight loans to meet Federal Reserve requirements. Floating-rate notes include corporate debt, especially bond issues of financial companies.
Beyond the benchmark rate, floaters have a spread, which is the margin the bond carries above or below the benchmark rate. The spread typically remains the same throughout the bond term. For example, if a floater is offered at LIBOR plus 0.50 percent, the rate will vary and be calculated as current LIBOR plus one-half of 1 percent. Spreads on floating-rate notes can also be negative, with basis points subtracted from the benchmark rate.
You can invest in individual floating-rate notes through many brokerages. Be aware that brokerages often require a minimum deposit for new investors to open accounts involving active trading. If you already use a brokerage service, check with the company to see if access to floating-rate notes is offered.
Exchange-traded funds are investments that put together a basket of securities. Investors can then buy and sell shares of the fund. An ETF trades at market price, not at net asset value like mutual funds, and shares are bought and sold like shares of common stock. An ETF that invests in floaters will typically hold bonds with varying maturities and coupon rates. The underlying securities, which are the actual floating-rate notes, when aggregated, determine the overall yield the fund earns. When interest rates in the overall market go down, income earned by a fund investing only in floating-rate notes will generally decline as the underlying investments produce less revenue. Be aware of expense ratios and sales charges if you choose ETFs as a means of investing in floating-rate notes. Fund expenses cut into earnings.
A third means of investing in floating-rate notes is to buy into mutual funds that invest in floaters. As with ETFs that invest only in floating-rate notes, a mutual fund that owns floaters exclusively will experience ups and downs in value, based on changes in the rates payable on the floaters that the fund owns. Consider expense ratios when comparing funds, as higher fees can significantly reduce investor profits over the long-term. Also, a mutual fund may require a minimum deposit for the initial purchase.
According to an August 2011 article on the SmartMoney website, the Financial Industry Regulatory Authority had issued a warning to investors the previous month on the risk of floating-rate funds that invest exclusively in bank loans. FINRA cautioned investors that this type of floater carries a higher risk than investment-grade bonds. The yield on these funds, higher than stock or bond funds, attracts investors who can tolerate the higher risk. With this type of floater, earnings increase if short-term interest rates increase.