Legal Definitions - inverse-floating-rate note

An inverse-floating-rate note is a type of debt instrument, similar to a bond, where the interest rate paid to the investor moves in the opposite direction of a specified market interest rate benchmark. This means that if the benchmark interest rate rises, the interest rate paid on the note falls, and if the benchmark interest rate falls, the interest rate paid on the note rises. Investors who purchase these notes typically anticipate a decline in overall market interest rates, as this would lead to higher income from their investment.

Here are some examples to illustrate this concept:

• Corporate Financing: A technology company issues inverse-floating-rate notes to fund its expansion into new markets. The terms of the note state that the interest rate paid to investors will be 9% minus the current 3-month SOFR (Secured Overnight Financing Rate). If the 3-month SOFR is 4%, investors receive 5% (9% - 4%). However, if the 3-month SOFR drops to 3%, the investors' interest rate increases to 6% (9% - 3%). Conversely, if SOFR rises to 5%, their interest rate would fall to 4% (9% - 5%).

  This example demonstrates how the interest income for the investor moves inversely to the benchmark SOFR. As the benchmark rate decreases, the investor's return increases, and vice-versa.

• Municipal Bond Investment: A local government issues municipal inverse-floating-rate bonds to finance a new public transportation system. The interest rate on these bonds is set as a fixed rate of 6.5% minus the prevailing 1-month Treasury bill rate. If the 1-month Treasury bill rate is 1.5%, bondholders receive 5% (6.5% - 1.5%). If the Treasury bill rate subsequently falls to 1%, the interest rate on the municipal bonds would rise to 5.5% (6.5% - 1%). If the Treasury bill rate climbs to 2%, the interest rate paid to bondholders would decrease to 4.5% (6.5% - 2%).

  This example illustrates the inverse relationship in a municipal bond context. The income stream for the bondholder increases when the underlying Treasury rate falls, aligning with the definition of an inverse-floating-rate note.

• Structured Investment Product: A financial institution offers a structured investment product to its clients, designed as an inverse-floating-rate note with a more complex formula. The note's interest payment is calculated as 12% minus two times the current prime rate. If the prime rate is 4%, the interest paid is 12% - (2 * 4%) = 12% - 8% = 4%. If the prime rate drops to 3%, the interest payment increases to 12% - (2 * 3%) = 12% - 6% = 6%. However, if the prime rate rises to 5%, the interest payment would decrease to 12% - (2 * 5%) = 12% - 10% = 2%.

  This example shows how even with a multiplier, the fundamental inverse relationship holds: as the benchmark prime rate increases, the interest income from the note decreases, and when the prime rate falls, the income increases.