Reverse Floater Bonds, What They Are, Calculation and Risks

Stock market investors are constantly looking for instruments that can offer attractive returns and portfolio diversification. Among the various options, reverse floater bonds are attracting the attention of many. These are debt securities whose interest rate varies inversely with respect to a reference index, often a short-term interest rate such as Euribor.

A typical example is represented by fixed reverse floaters. They are generally long-term bonds that pay fixed initial coupons that are higher than current market rates.

In a context in which interest rates can undergo significant fluctuations, let’s find out together how reverse floater bonds work and how to exploit their potential without incurring uncalculated risks.

What are reverse floater bonds? Let’s give a definition

reverse floater bonds are a particular type of variable rate securities in which the coupon, or the interest rate paid to the investor, moves in the opposite direction to a reference index.

In other words, when the reference index increases, the coupon decreases, and vice versa. This inverse behavior distinguishes them from traditional floating rate bonds, where the coupon directly follows the variations of the index.

Let’s try to summarize the main characteristics.

• Reverse indexation: the coupon is calculated by subtracting the value of the reference index from a predetermined constant. For example, if the constant is set at 10% and the reference index is at 3%, the coupon will be 7% (10% - 3%).
• Coupon frequency: coupons can be paid quarterly, semi-annually or annually, depending on the conditions specified at the time of issue of the bond.
• Duration: the maturity of reverse floaters varies based on the issue, and can range from a few years to longer periods. Duration affects the sensitivity of the bond to changes in interest rates.

Reverse floater bonds are often issued in periods when interest rates are expected to decrease. Issuers, such as banks or financial institutions, use these instruments to attract investors by offering potentially higher returns in scenarios of decreasing rates. For investors, these bonds represent an opportunity to benefit from higher returns when market rates decrease.

Reverse floater bonds: how they work (and advantages)

When analyzing reverse floater bonds, it should also be emphasized that the advantage for the buyer consists in the perception, at the beginning of the life of the bond, of coupons higher than the market rates even if it is exposed to the risk of a possible future increase in interest rates.

This is because, in such a situation, the coupon that the buyer would collect could become zero. Precisely for this reason, a minimum threshold, called a floor, is usually provided, which prevents the coupon rate from becoming negative.

It must also be said that the purchase of a reverse floater security can be broken down into:

• purchase of a long-term fixed-coupon bond;
• purchase of an Interest Rate Swap (IRS) with an effective date coinciding with the liquidation date of the last fixed-rate coupon of the security;
• purchase of a series of Interest Rate Cap coverage.

Finally, it is important to underline that the volatility of the price of a reverse floater security is greater than that expected for a normal variable-coupon security with similar characteristics. For this reason, the reverse floater bond is a bond for risk-loving investors.

Limits and clauses

Some reverse floater bonds may include specific clauses, such as:

• floor: this sets a lower limit on the coupon, protecting the investor from too low a yield. For example, if the floor is set at 3%, even if the formula calculates a coupon lower than that value (for example, 2%), the investor will still receive 3%. This clause serves to protect investors in very high interest rate environments, limiting the negative impact on coupons;
• cap: another protection mechanism is the cap, which sets an upper limit on the coupon. This is advantageous for the issuer, who wants to avoid too high a coupon payment in sharply declining interest rate scenarios. For example, if the cap is set at 7%, even if the coupon calculation were to result in a higher value (say, 9%), the investor would never receive more than 7%.

Who should invest in reverse floater bonds?

Reverse floater bonds can be particularly attractive to investors with a certain tolerance for risk, as their returns can be more volatile than those of traditional bonds. Here are some investor profiles that might be worth considering these bonds.

Investors who expect interest rates to fall

• Reverse floater bonds are designed to benefit from a falling interest rate environment. If an investor expects Euribor, Libor or another short-term benchmark rate to fall in the near future, a reverse floater could prove to be an advantageous choice. In this case, a fall in the benchmark index will lead to an increase in the coupon, with yields higher than those of traditional fixed-rate or floating-rate bonds.

Investors with a diversified portfolio

• Reverse floater bonds can play an important role in a well-diversified portfolio. Although they carry a higher risk, as rates can change rapidly and unexpectedly, the inclusion of securities with a complex payment structure can improve the overall risk-return profile of a diversified portfolio. In particular, for investors who already hold fixed or floating rate bonds, adding reverse floaters could offer protection against declining rate scenarios.

Investors with a medium- to long-term investment horizon

• Reverse floater bonds tend to be more suitable for investors who have a medium- to long-term investment horizon. Since coupon performance depends on the movement of short-term interest rates, a longer horizon allows the investor to benefit from favorable periods when rates are low, maximizing returns.

Investors willing to take volatility risk

• The inverse nature of the interest rate means that reverse floater bonds are exposed to the volatility of market interest rates. Investors willing to accept this volatility, who may be attracted to high yields during periods of falling interest rates, can benefit from these bonds. It is crucial that the investor is aware of the possibility of seeing their yields reduced when rates rise.

Investors seeking above-average yields

• In a low interest rate environment (like the one that could continue into 2025), investors seeking higher yields than traditional bonds may find reverse floaters an attractive opportunity. Fixed rate bonds and traditional floating rate bonds offer relatively low yields, while reverse floaters may offer higher yields during periods of falling rates.

Reverse Floater, what are the risks?

Although reverse floater bonds may seem attractive due to the high returns they offer in certain scenarios, they also carry a number of risks that must be carefully considered before investing.

1. Interest rate risk: The main risk associated with reverse floaters is interest rate risk. Since the coupon varies inversely with respect to the reference index, if market rates increase, the coupon paid by the issuer will be reduced. In a scenario of rising interest rates, the investor would find himself receiving a lower coupon, which could significantly reduce the overall return on the investment. This is particularly problematic if the investor has purchased the bond with the expectation of stable or increasing returns.
2. Liquidity risk: Due to their complex structure and relatively less popular than traditional bonds, reverse floater bonds may be less liquid. This means that it may be difficult for the investor to sell the bond in the secondary market without having to accept a price lower than the face value. Limited liquidity may also negatively impact the ability to exit a position quickly if market conditions suddenly change.
3. Issuer Credit Risk: As with any bond, credit risk is an important factor to consider. If the issuer of the reverse floater bond were to experience financial difficulties or go bankrupt, the investor may not receive coupon payments or principal at maturity. Investors should always evaluate the financial strength of the issuer before purchasing reverse floater bonds.
4. Complexity and Understanding Risk: Reverse floater bonds can be difficult for less experienced investors to understand. The complex structure of the coupon calculation, combined with the variability of interest rates, requires a thorough understanding of financial market dynamics. If an investor is not fully aware of the risks associated with this instrument, they may find it difficult to manage their investment.
5. Risk of fluctuations in reference rates: since the coupon is directly linked to the performance of a reference index, any unexpected fluctuation in that index (such as a sudden increase in Euribor) could significantly impact the return. If the investor has not adequately anticipated a change in rates, they may find themselves with a lower coupon than initially expected, negatively impacting their financial return.

Original article published on Money.it Italy. Original title: Obbligazioni Reverse Floater, cosa sono, calcolo e rischi