Bonds and the Floating Interest Rate

A floating interest rate is similar to a variable interest rate because it will go up and down over the life of the particular investment. For example, a floating interest rate mortgage will have an interest rate that varies with a particular index, such as the national prime rate. The concept is the same with a floating rate bond. The interest rate on the investment will go up and down with a particular market variable. Floating rate bonds have many advantages.

Compensate for Inflation

One of the largest risks with a bond investment, which is generally very low-risk, is the effect of inflation. If you purchase a typical 10-year Treasury bond, the chance you will lose your principal investment is zero. The chance the interest earned on the bond will be too low to actually make you any money when compared even to a standard savings account rate, though, is moderate. If inflation rises rapidly over a 10-year period and the bond rate does not, you will fail to earn income on the investment. Floating interest rates can partly compensate for this. They will rise with a market indicator; typically, this indicator is one that will rise with inflation. 

Floating Interest Rate Example

For example, imagine you purchase a municipal bond with a floating interest rate. That rate will consistently remain at one half point above the national prime interest rate. One year into the life of the bond, lenders begin extending too many loans, inflating the money in the market and therefore lowering the value of a dollar. Your bond rate will not be as competitive as it was when you purchased the bond. However, the Federal Reserve notes the effect of too many loans on the market, and it raises the national prime rate by one quarter of a point. This will cause your floating interest rate also to increase by one quarter of a point. The effect is a consistent interest rate over time even though that interest rate varies.

Market Indicators Used for Floating Rate Bonds

The national prime rate is just one of the many indicators that may be used for floating interest rate adjustments on bonds. At times, inflation itself is used to set the floating rate. Some bonds even use a market index indicator--raising the interest rate as the S&P 500 or Dow Jones also goes up. Regardless of the indicator, though, the goal is always to keep the interest rate competitive relative to the rest of the market.

Downsides of Floating Interest Rates

There are still some risks with a floating interest rate. First, there is always the chance the market will drop while you hold the bond. In this case, the interest rate would decrease instead of increasing. Most floating interest rate bonds guarantee the rate will never drop below zero, protecting you from losing your principal investment. Ultimately, though, floating interest rates are as unpredictable as the market indicators with which they rise and fall. If you are an investor who likes solid, predictable returns, you may opt for a more traditional interest rate model on your bonds.

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