Legal Definitions - inverse floater

An inverse floater, short for inverse-floating-rate note, is a type of debt instrument, like a bond, where the interest payments (or coupon rate) move in the opposite direction of a specified benchmark interest rate. This means that as the benchmark rate rises, the interest paid on the inverse floater decreases, and conversely, as the benchmark rate falls, the interest paid on the inverse floater increases.

Inverse floaters are often created from a fixed-rate bond that is split into two components: a "floating-rate note" (whose interest rate moves in the same direction as the benchmark) and an "inverse-floating-rate note." Investors who believe interest rates will fall might find inverse floaters attractive because their income stream would then increase.

Here are some examples to illustrate how an inverse floater works:

• Municipal Bond Example: A city issues a bond to fund a new public park. Instead of a traditional fixed-rate bond, they structure a portion of the offering as an inverse floater. This inverse floater pays interest based on a formula like "10% minus the 3-month SOFR rate." If the 3-month SOFR (Secured Overnight Financing Rate) is 2%, the bond pays 8% interest (10% - 2%). However, if the SOFR rate rises to 4%, the bond's interest payment drops to 6% (10% - 4%). Conversely, if SOFR falls to 1%, the bond's interest payment increases to 9% (10% - 1%). This demonstrates the inverse relationship between the benchmark rate and the bond's interest payments.

• Corporate Financing Example: A large technology company needs to raise capital for expansion. They issue a series of notes, some of which are inverse floaters tied to the Prime Rate. The terms state that the inverse floater will pay an annual interest rate calculated as "12% minus the current Prime Rate." If the Prime Rate is 5%, investors receive 7% interest (12% - 5%). If the Federal Reserve raises interest rates, causing the Prime Rate to climb to 7%, the interest paid on the inverse floater would fall to 5% (12% - 7%). Should the Prime Rate drop to 4%, the interest payment would rise to 8% (12% - 4%). This illustrates how a company might use such a structure in its debt offerings, and how the investor's return is inversely linked to a widely followed interest rate benchmark.

• Structured Investment Product: An investment bank creates a complex financial product for institutional investors, which includes a component that behaves like an inverse floater. This component is designed to provide enhanced returns if short-term interest rates decline. For instance, it might be linked to a formula like "15% minus twice the 6-month Euribor rate." If the 6-month Euribor (Euro Interbank Offered Rate) is 2%, the component pays 11% (15% - 2*2%). If Euribor falls to 1%, the payment increases to 13% (15% - 2*1%). However, if Euribor rises to 4%, the payment would decrease to 7% (15% - 2*4%). This shows how inverse floater characteristics can be embedded within more sophisticated investment vehicles, offering specific interest rate exposure.