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A reverse floater is a type of debt instrument that allows investors to benefit if prevailing interest rates start to fall. These instruments are usually set up as bonds that are sold by institutions like corporations or government agencies that raise funding by selling them. Investors can get increased yields from a reverse floater if some benchmark rate falls. This is because the coupon rate on this type of bond is usually set up as a fixed rate minus the benchmark, so if the benchmark goes down, the coupon will rise.
Most bonds pay fixed interest rates to investors at periodic intervals, thus allowing investors to receive fixed income. There are certain types of bonds that are known as floating rate debt. This is because the interest paid to the investor can fluctuate depending on the conditions agreed upon at the beginning of the bond agreement. One such type of bond is known as a reverse floater because the rate paid to investors moves in inverse proportion to whatever benchmark interest rate is used.
When an investor buys a reverse floater, he or she is trying to protect against the possibility of falling interest rates in the market in which the bond is traded. To do this, these bonds determine the coupon rate, which is the rate at which interest is paid when compared to the principal, by taking a fixed coupon rate and then subtracting a benchmark rate that is an indicator of prevailing interest rates. This means that the coupon can periodically rise and fall.
In many cases, the benchmark rate is the London Interbank Office Rate (LIBOR). Banks borrow from each other using the LIBOR rate, so it acts as an excellent reference for a LIBOR transaction. As an example, an investor might buy a reverse floater in which the fixed rate is 10 percent and the LIBOR in the particular bond market is four percent. His first coupon payment would be six percent of the principal, based on the 10 percent fixed rate minus the four percent LIBOR. If LIBOR should fall to three percent, the next interest payment would be seven percent, or 10 percent minus three percent.
The main drawback of a reverse floater is that rising interest rates will cause a negative effect on the bond's coupon payment. This is because the rising reference rate means that more will be subtracted from the predetermined fixed rate. Investors who want to know exactly what they're getting with each interest payment should probably avoid floating rate debt because of the uncertainty involved.