When an investor buys a variable rate security, the borrower pays the investor interest payments throughout the life of the security and the par value of the security at maturity, like a fixed rate security. The main difference between fixed rate securities and variable rate securities is that unlike fixed rate securities, the interest rate for variable rate securities is adjusted periodically such as weekly or monthly, based on market conditions.
Most variable rate securities are pegged to an index like the Secured Overnight Financing Rate (SOFR) or the SIFMA Municipal Swap Index. Bonds with interest rates adjusted by a predetermined index are called floating rate securities or floaters. Interest rates are reset periodically at some fixed spread above the selected index. The spread, remaining constant throughout the security’s life, might be 1.00% above the index. As the index moves due to market conditions so does the variable rate the borrower pays the investor. Should the credit rating of the borrower improve or decline, the rate could also change.
A risk to the issuers of variable rate securities is that investors can sell the variable rate debt back to the borrower whenever a rate change occurs. The borrower would then have to either find a new investor for the security or redeem it.
The borrower must therefore have access to sufficient funds to pay for redeemed securities. The borrower can either:
- Self-liquidate with cash on hand
-
Hire a letter-of-credit bank responsible for supplying cash when a bond is returned to the issuer. The borrower then sells the bond back into the open market and repays the letter-of-credit bank with the proceeds.
What’s important here?
Issuers can choose to issue variable rate debt, which is a long-term loan or bond with interest rates that reset on a short-term basis. Interest rates may be reset daily, weekly, monthly, or annually. Common indices include the SOFR, the federal funds rate, and 3-month, 6-month, and 12-month Treasury bill rates.
