An inverse floater (or inverse floating rate note) is a capital guaranteed product with a link to an interest rate. The product pays a coupon depending on the evolution of that interest rate. The coupon calculation is quite simple: the reference interest rate (or a multiple thereof) is deducted from a constant on every coupon date. The result equals the coupon for that period.
The coupon formula is often equal to:
[Constant Number – Ratio x Reference Rate]
An inverse floater compares to either fixed-coupon bonds or floating-rate bonds. It is especially interesting to favour an inverse floater when the reference interest rate is high but expected to decrease, or when the reference interest rate is low, but the forwards are steeply up and your forecasted scenario is continuous low rates. In other words, the market is implying higher rates, but you don’t believe in it. It must be said that the forward rates have seldom predicted the actual future rates with accuracy.
Payoff and numerical example
For instance, in September 2009, the short-term interest rate in EUR (the 3-month EURIBOR) was at 0.5%, and the forward curve was rising rather steeply (the implied forward 3-month EURIBOR in 3 years was at 3.3%). The 3-year interest rate for a fixed-coupon bond was at 3.5% at the time. It was possible to construct a 3-year bond paying:
[6% - 2 x 3M EURIBOR]
The coupon payments usually occur on a quarterly basis. Should the 3-Month EURIBOR not move during the first year, the coupon would amount to 6% - 2 x 0.5% = 5%. Compared to a floating rate bond, the outperformance would be 4.5% for that period. The issuer for such a product would have had a rating of A+ / A2. After 3 years, the invested nominal is redeemed along with the last coupon.
- Invest in an inverse floater when the reference rate is high and you expect it to decrease faster than the forwards imply or when the reference rate is low, the forwards are implying a steep increase but you don’t believe in it.
- Choose the reference rate that you expect to decrease: the 3-month EURIBOR, the 2-year CMS (Constant Maturity Swap) or the 10-year CMS.
- Don’t select an issuer with a credit rating that is likely to decrease during the lifetime of the product.
- Don’t invest in an inverse floater when you expect the rates to increase. Choose a floating rate note or a floored floater instead.
- Inverse floater on the 2-year CMS: the reference rate is a two-year constant maturity swap.
- Inverse floater linked to inflation: the constant number is reduced by the year-over-year inflation or a multiple thereof (e.g. 6% - 1.5 x inflation). Use a similar variant when the expected inflation is high but you think the forecast is too high.