Floored Floaters are capital guaranteed products falling in the range of the fixed income asset class. They pay a yearly, semi-annually or quarterly coupon that is linked to an economic variable such as the 3-month LIBOR (London Interbank Offered Rate). In addition, if the economic variable is lower than a predefined floor, then that floor determines the level of the coupon.
If the prospects favor a rising interest rate scenario, fixed-coupon bonds are not recommendable, because the price of such bonds would fall. On the other hand, floating rate bonds often yield very small coupons because of the link to the short term-rates, which are typically lower than the long term rates (in a normal rising yield curve environment). As such, floored floaters are ideal instruments in a rising rate scenario. They pay a minimum fixed coupon of X%, and a variable rate + Y% if the latter is higher than the former.
The graphic on the right shows an example of a 3-year floored floater, which would pay a minimum fix coupon of 3.5% or 3-month LIBOR + 50 basis points, whichever is higher. The only risk the holder of such a product takes is the issuer risk. Indeed, were the funding spreads of the issuer to widen, then the mark-to-market price of the floored floater would fall. Interest rate level variations have little impact on the product once issued; since the holder always receives the higher of the two rates (floor or floating), no matter whether the basis (i.e. the 3- or 6-month LIBOR) rises or falls, the mark-to-market price of the floored floater will stay around par.
These products became quite popular in the wake of the financial crisis in 2009, as the issuer’s funding rate reached unprecedented highs and investors looked for higher income than the low “risk-free” rates yielded. If an investor was willing to take a particular issuer‘s risk, then he could generate a huge outperformance compared to money-market instruments.
- Do invest in floored floaters when you think that the credit spread or funding rate of a particular issuer will decrease.
- Do invest in floored floaters when short-term interest rates (e.g. 3- or 6-month Libor rates) are low, but the yield curve is steeply increasing in the longer term.
- Don’t select a maturity that goes over your investment horizon.
- Don’t expect the mark-to-market of the product to move strongly unless the credit spread or funding rate of the issuer also strongly moves to the upside or the downside. In other words, expect to hold the product until maturity; it is not designed for trading in and out.
- In most cases, avoid Floored Floaters with Cap. Reason: unless the interest rate curve is particularly flat, the cap often yields a negligible increase in the Floor (e.g. from 3.5% to 3.7% for the above-mentioned structure if the cap was placed at 5%). However, the mark-to-market price of the product is negatively impacted by any future increase in medium and long-term interest rates.
- Capped Floored Floater: same as Floored Floater, but the coupon cannot increase past the cap.
- Ratchet Floored Floaters: same as floored floater, but the coupon cannot decrease below the highest coupon already paid.
- Leveraged Floored Floaters: same as floored floater, but the minimum coupon that is linked to the short-term rate (eg. LIBOR) has a leverage factor. For example, Min. 3% or 1.5*LIBOR.
- None, except the issuer's credit risk. Compare the floored floater to a floating rate note of the issuer with the same maturity. If the FRN is trading at a steep discount, it may be more worthwhile to purchase the FRN instead of the floored floater. Also compare the Floored Floater of the issuer to a fixed-coupon bond of the same issuer.