You might like to take advantage of the rise of bond prices that can occur when bond interest rates have climbed so high that the only place for them to go is down. When you believe that interest rates are about to slide, you might simply invest in bonds and bond funds. But if you are more aggressive, you may want to adopt a strategy that provides higher bond prices and higher rates. Reverse floater blonds afford just such an opportunity.
Bonds pay interest. A fixed-rate bond pays its stated rate, or coupon, until it matures, at which point it returns its face value to its owner. Since the coupon is fixed, the attractiveness of the bond depends on how the coupon compares to the returns, or yields, from competing financial instruments. Short term bonds tend to pay less interest than do long-term bonds, due to the uncertainty of future interest-rates over the long haul. Short-term bonds also have greater price stability because they are near maturity, at which time they will pay back their face values.
Floaters are short-term bonds with adjustable coupons that respond to changes in interest rates. As rates change, so do floating coupons. This tends to lower the bond’s sensitivity to changing rates, because the floater will catch up with new bonds issues with higher or lower coupons. However, floaters do not catch up instantaneously, so their prices can lag behind newly issued bonds, especially if the rates change rapidly. Issuers of floating-rate bonds often specify maximum and minimum rates, called caps and floors. Should prevailing interest rates rise above the cap or fall below the floor, the floating bond behaves like a fixed-rate security with a coupon equal to the cap or floor.
A reverse floating-rate bond, also a short-term instrument, is usually created in tandem with a regular floater, often by a trust that holds newly issued fixed-rate bonds as collateral. They can also be created by an interest rate swap, a contract in which the buyer of the fixed-rate bond swaps a commitment to receive the interest on an inverse floater in exchange for paying the interest on the fixed-rate bond. In either case the holder of the fixed-rate bond will typically create both floaters and reverse floaters in some ratio. Both the floater and inverse floater are pegged to a reference short term interest rate like Fed Funds. The floater coupon moves directly with the reference rate but the inverse rate changes by the difference between its stated rate and the reference rate.
Example of a Reverse Floater
Suppose Fed Funds is set at 5 percent when the reverse floater is issued with a stated rate also of 5 percent. The reverse bond has a floor of zero percent and a cap of 9 percent.
If the Fed Funds rate falls two percentage points to 3 percent, the reverse floater rate rises to 7 percent — the stated rate of 5 percent plus the change to the Fed Funds rate of 2 percent. The holder of the reverse floater benefits from a higher coupon plus a rise in value of the reverse floater. If the Fed Funds rate falls below 1 percent, there reverse floater is capped at 9 percent.
However, if Fed Funds rises to 7 percent, the reverse floater’s rate will fall to 3 percent, making it unattractive and hard to sell, even at lower prices. If Fed Funds zoom up above 10 percent, the reverse floater pays zero interest.