What are floating rate bonds?

Floating rate bonds, also called floaters or variable-rate notes, pay interest coupons that reset periodically based on a reference rate plus a fixed spread. For example, a corporate floater might pay SOFR plus 150 basis points, resetting every three months. When SOFR rises, the bondholder receives higher interest payments; when it falls, payments decrease. This mechanism means floaters carry minimal duration risk, making them attractive when interest rates are rising.

The reference rate has evolved over time. Before 2023, most dollar-denominated floaters referenced LIBOR. Following LIBOR's discontinuation, the market transitioned to the Secured Overnight Financing Rate (SOFR). Government-issued floating rate notes (FRNs) from the US Treasury reference the 13-week T-bill rate. The fixed spread added to the reference rate compensates investors for the issuer's credit risk and remains constant over the bond's life.

Floating rate instruments occupy a distinct role in portfolio construction. During tightening cycles, when the Fed is raising rates, traditional fixed-rate bonds lose value as their coupons become less competitive. Floaters, by contrast, see their income stream increase in step with policy rates. This made floating rate funds among the best-performing fixed income categories during the 2022-2023 hiking cycle. The tradeoff is that floaters underperform during easing cycles, as falling reference rates reduce their income.

The leveraged loan market is the largest source of floating rate exposure. Leveraged loans are bank loans to below-investment-grade companies that typically pay SOFR plus 300-500 basis points. These loans are bundled into collateralized loan obligations (CLOs), which have become a core holding for institutional investors seeking floating rate income. Understanding floaters is essential for investors navigating interest rate risk, as they provide a natural hedge against the scenario that fixed-rate bond investors fear most: sustained increases in the policy rate.