Managing Interest Rate Risks with Floating Rates

Introduction

Floating rate instruments are important in finance markets as they present a mechanism both to the borrowers and the lenders for dealing with the risks of varying interest rates. As opposed to fixed rate instruments in which the interest rate is constant for the life of the financial instrument floating rates are modified periodically in relation to shifts in an underlying benchmark interest rate.

Floating Rate bonds and loans are important instruments in finance that have direct implications on corporate government and individual borrowers. Investors companies and governments have used floating rate instruments for decades as an efficient vehicle for managing risks that occur in the uncertain changes in interest rates under varying economic environments.

The central bank increases and decreases its policy rate to guide the economy toward inflationary targets and full employment as it does so that impacts all interest rates along the yield curve and creates a very dynamic and important part of the floating rate instruments in the market.

What is a Floating Rate?

A floating rate or variable/adjustable rate refers to an interest rate that changes as the changes in a particular benchmark or reference rate change. The reference rate is mostly any recognized interest rate for example the London Interbank Offered Rate (LIBOR) the Secured Overnight Financing Rate (SOFR) or the policy rate of a central bank such as the Federal Reserve’s Federal Funds Rate.

The floating rate is quoted as the reference rate plus a spread or margin which compensates the lender for taking on the risk associated with lending. For example if a floating rate loan has an interest rate of LIBOR + 3% the interest rate on the loan will move in lockstep with LIBOR plus the extra 3% spread.

Key Elements of a Floating Rate

Reference Rate

The floor rate which is quite often the market interest rate or central bank policy rate.

Spread (Margin)

This is above the reference rate that reflects the risk premium.

Reset Period

How often is the interest rate reset? It is usually quarterly semiannually and annually.

Floating Rate Instrument Types

Floating rate instruments can be found in several forms. They have been developed to meet the various needs of the financial market. Some of the most widely utilised ones are summarised below.

Floating Rate Bonds FRNs

A floating rate bond also known as a floating rate note (FRN) is a debt in which the interest payments change with changes in a reference rate. The interest on these bonds resets periodically usually every three to six months. FRNs attract the investors attention especially when interest rates are anticipated to rise because the periodic adjustment protects the value of the bond.

Characteristics

The coupon payments are floater and get indexed to the reference rate say LIBOR or SOFR.

More often issued by governments financial institutions and corporate

Protect against interest rate risk.

Example

A corporate bond issue with a rate of SOFR + 150 basis points (bps) would get its coupon payments adjusted based on the fluctuations in SOFR so that the interest is reflected based on market conditions.

Floating Rate Loans

Floating Rate Large firms frequently use floating rate loans as part of debt financing within corporate finance. The interest rate will periodically reset off a benchmark rate such as LIBOR or prime according to the loan period.

 Features

Generally resets interest periodically typically based upon benchmarks.

Most often used in syndicated loan markets for large firms.

Flexibility to both the borrower and the lender within the floating rate environment due to changes in interest rates.

Adjustable Rate Mortgages (ARMs)

ARMs are the most common type of floating rate product in the retail banking business. While in a fixed rate mortgage the rate stays the same over the term of the loan in an ARM the rate changes periodically based on an index.

Characteristics

ARMs are indexed to a prime rate or Treasury yields.

They begin low but the rate can rise or fall based on the market.

ARMs tend to renew annually after an initial fixed period (for example 5/1 ARM fixed for five years then adjusts annually).

Floating rate instruments will likely have their interest payments reset at periods defined by certain rules. These rules often find a convenient nexus to take cues from market based interest rates the stance of the central bank and general broader economic conditions.

Interest Rate Benchmarks

LIBOR and SOFR are the two most important benchmarks underpinning most floating rate instruments. A cursory look at these benchmarks would give an idea of how the broader market influences floating rate products

LIBOR

The London Interbank Offered Rate is one of the most widely used benchmarks for floating rate products but outdated and phased out due to issues of manipulation and lack of accuracy currently being replaced by alternatives such as SOFR.

SOFR is the secured overnight financing rate a benchmark rate measuring the cost of overnight cash borrowing collateralized by the U.S. Treasury securities. For that reason it has emerged in recent years as the more reliable alternative to a significantly more troubled LIBOR over the past year.

Prime Rate

This is a base rate for most types of loans including ARMs. It refers to the interest rate charged by a bank to its best customers for lending purposes.

Spread and Risk

The spread refers to the margin over the reference rate that is added as compensation for credit risk liquidity risk and other factors. It depends on the creditworthiness of the borrower the kind of risk attributed to the loan and market conditions. A generally higher risk borrower receives a wider spread.

Reset Periods

Reset periods define the intervals at which floating rate products adjust their interest rates. Common reset periods are quarterly semiannually or annually depending on the terms of the contract. The reset period can significantly impact the product’s sensitivity to interest rate fluctuations. For example a product with quarterly resets will react more quickly to changes in market rates compared to one with annual resets.

Factors Influencing Floating Rates

There are many reasons behind the floating rates in terms of changing attractiveness to both borrowers and lenders. These include

Monetary Policy

Central banks affect floating rates through policy decisions similar to the Federal Reserve. With the Fed’s benchmark interest payments on floating rate products will rise when the Federal Reserve increases the Federal Funds Rate. For example if the Federal Funds Rate increases the interest payments increase.

Inflation Expectations

Float rate instruments are sensitive to inflation. When the expectations of inflation are high the central bank might raise the interest rate to reduce inflation. Hence floating rates go up however when inflation is low the central banks tend to cut rates which makes the rate product cheap.

Supply and Demand in the Market

Floating rates also depend on the supply and demand of credits in the market. During high demand borrowing the spreads for floating rate loans and bonds may be wider to represent increased credit risks but during lower demand conditions one may find wider spreads.

Economic Growth

During economic expansions interest rates become higher due to central banks wanting the economy not to overheat. Such factors are reflected in floating rate instruments that make it more expensive for lenders. Conversely floating rate instruments tend to be cheaper to borrow during economic recessions where rates decline.

Credit Risk

The credit quality of the borrower is also one aspect that determines the spread over the reference rate. Lenders earn higher spreads on floating rate instruments for riskier borrowers. For example companies with lower credit ratings issue floating rate bonds with wider spreads than firms with higher rated borrowers.

Floating Rate Products Advantages

Floating rate instruments have many advantages particularly in specific types of economic environments. Some of the benefits include

Protection Against Higher Interest Rates

Floating Rate products are particularly appealing where interest rates are high. With the floating rate tied to the benchmark lenders and borrowers cannot get locked in a fixed rate when the economy is unstable. Periodic rate adjustments present higher returns for investors in an environment of upward floating rates.

Flexibility

The floating rate loans have the advantage that borrowers get to take advantage of decreasing rates. When the rates go down their interest payments decrease and thereby debt becomes cheaper. For example a company that has a floating rate loan can strategically seize the low borrowing opportunity by using the resources for other tasks during low interest periods.

Possibility of Lower Prime time Costs

Many floating rate products for example adjustable rate mortgages start at lower interest rates than their fixed rate counterparts. This may be more appealing to the borrower who will likely sell or refinance before the rates begin to change.

Hedging Against Inflation

Floating rate instruments are a very effective hedge against inflation. Since they depend on the rates for interest pay the erosion of purchasing power due to inflation will be warded off.

Disadvantages of Floating Rate Products

Though floating rate products have many advantages they also carry certain risks and downsides especially in uncertain economic environments.

Uncertainty and Volatility

The major risk involved in floating rate instruments is the uncertainty of future interest payments. In the case of fixed rate instruments the borrowers know exactly how much they will pay over the term of the loan whereas with floating rate borrowings they face the risk of rising rates which are likely to increase their debt servicing costs substantially.

Higher Long Term Costs

With floating rate products though the initial interest rate is low it will shoot up over a period. If the rates increase floating rate loans may become much more expensive than other fixed rate loans.

Complexity

Floating rate instruments are more technical in comparison to fixed rate instruments and require better knowledge of financial markets as well as rate movements. Both borrowers and investors need to have a good understanding of reference rates spreads and reset periods for their proper functionalities. Inexperienced users may need to accurately predict when changes will occur and how to handle floating rate volatility properly.

Limitations of Interest Rate Cap

Some floating rate products including ARM feature interest rate caps. These limit how much the rate can advance over an intervening reset period. This does offer some level of protection but the cap may still be positioned at a point where the cost will increase significantly. Moreover at extreme points of instability no amount of rate cap can fully eliminate the risks involved with rising rates.

Sensitivity to Economic Shocks

Floating rate products are extremely sensitive to general economic shocks and central bank moves. An unsuspected shock to the economy would come for instance in the form of a financial crisis or an unexpected rise in inflation making interest rates go through a violent oscillation cycle making it difficult to budget the borrowers financial obligations. For instance borrowers with floating rate mortgages were faced with sky high payments during the financial crisis of 2008 due to the volatility in lending markets.

Floating Rate vs Fixed Rate

When one is faced with a decision between floating rate and fixed rate financial products the decision will be made based on a number of factors that include the borrowers or investors level of risk tolerance expectations about the future movement of interest rates or generally the economic environment. Knowing the difference between these two types of rates gets one on the right footing in terms of deciding on a way to make financial decisions.

Stability vs Flexibility

Fixed Rate

A fixed rate product offers stability because the interest rate is fixed for the term of the loan or bond giving both lenders and borrowers an idea of how much they are going to pay or receive in interest making it easier to budget. The floating rate provides market condition flexibility and adaptation. The flexibility is useful in falling interest rates but adds volatility when the rates are rising.

Interest Rate Environment

Fixed Rate 

A fixed rate loan is generally more attractive in a rising interest rate environment because it will lock in a lower rate before rates go higher. It’s less appealing in a falling interest rate environment because consumers have to lock into a higher rate.

Floating Rate products work best in times when interest rates are increasing because they do so as well allowing investors to take advantage of higher rates while they last. This type of product could be somewhat less appealing during falling rate periods where borrowers are at the mercy of rising interest rates elsewhere.

Cost

Fixed rate products tend to carry a premium cost of entry especially when market rates are high. Borrowers will typically pay a premium to lock in a fixed rate.

Floating rate products often carry lower cost of entry but these can rise sharply if market rates increase. This makes floating rate products cheaper in the short term but potentially costly in the long term.

Predictability

A major benefit of fixed rate products is predictability. The flows of payments are predictable over time.

A floating rate product is less predictable and the payments are affected by changes in the marketplace. They are more difficult to predict and plan for over extended periods.

Workings of Central Banks and Money Policy

The key influence on floating rates emanates from the central bank’s control over short term interest rates and monetary policy decisions. With benchmark interest rates there is a binding effect on borrowing costs money supply and inflation expectations. Any change in these benchmark interest rates will have a direct impact on floating rate products especially those related to central bank rates or closely correlated market benchmarks.

Interest Rate Targeting

Macroeconomic objectives which may include inflation control employment levels and the promotion of growth in an economy are managed by central banks such as the Federal Reserve the European Central Bank (ECB) and the Bank of England (BoE) through interest rate targeting. Central banks affect the entire range of interest rates in the economy by raising or lowering policy rates wherein the interest rates corresponding to floating rate instruments are included.

For example when the central bank increases the Federal Funds Rate floating rate instruments borrowing the benchmark of the U.S. will have an attraction for a higher interest payment. When the central bank cuts interest rates floating rate instruments will follow downwards and therefore reduce the costs of borrowing.

Controlling Inflation

Inflation targeting is a core element of modern central banking. As inflationary pressures build central banks typically raise interest rates as a policy tool to temper the economy and prevent inflation from getting out of control. It has direct implications on floating rate products which will increase as central banks push up rates in an inflationary environment.

In contrast during a low inflationary or deflationary period the central banks may attempt to reduce interest rates and stimulate borrowing and in the process pump up economic activity to their advantage with borrowers whose interest costs decrease due to floating rate loans.

Economic Boost

During an economic recession or slowdown central banks can start the cycle of economic growth by applying instruments such as QE or negative interest rates. This may pave the way for benchmark interest rates to become softer on the borrowers side for floating rate products. However investors in floating rate bonds would end up earning lower yields because the periodic interest rate resets track the overall decline in rates.

Conclusion

Floating Rate instruments are at the core of financial markets because of their flexibility and adaptability in case of changing interest rates. From floating rate bonds and loans to mortgages having an adjustable rate these products have two primary advantages making possible both a mechanism for managing the risk of interest rates and taking full advantage of market conditions for borrowers as well as investors.

However inherent risks are also attached to all these floating rate product schemes such as higher uncertainty and exposure to interest rate fluctuations. Understanding floating rate instruments through how they behave their reference rates and the risks associated are important for both borrowers and investors. Of course interest rate swaps and caps can be hedging strategies that allow for the inflow of floating rate advantages while protecting market participants from unfavourable rate changes.

More From Author

Braintree Gateway for Online Business Payments

Best Credit Cards for Bad Credit