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An inverse floater is a variable-rate security whose coupon rate changes in a direction opposite to that of a specified short-term interest rate. When the short-term interest rate drops, the amount of interest paid by the inverse floater increases. Typically, this leads to an increased yield and a greater market price. Inverse floaters are also called "inverse floating rate notes," "reverse floaters" or "residual interest bonds."
Inverse floaters are often issued in combination with floaters. A floater is a security with a coupon rate that varies based upon a short-term index rate. A floater usually possesses a reference rate, which is equal to the fixed percentage rate less the then-current rate. An inverse floater’s variable rate frequently equals the floater’s reference rate. As the inverse floater rate rises, the floater rate usually declines.
Caps and floors are often placed on inverse floaters in order to make them more attractive to investors. The cap represents the upper limit or ceiling price while the floor represents the lower limit or base price. The floor is usually set at zero, and the cap is typically set at an agreed upon percentage. When a floater is involved, a cap that matches the floor of the inverse floater may be placed on the floater.
Inverse floaters can be generated a number of ways, including through secondary bonds. Under this method, a dealer purchases a fixed-rate bond in the secondary market and puts the bond in a trust. The trust then issues both an inverse floater and a floater. Inverse floaters can also be created when an investment bank issues a new fixed-rate security and puts it into a trust. A floater and an inverse floater are then issued by the trust.
Another way to create inverse floaters is through entering into interest rate swap agreements. A swap agreement is a contract under which one party exchanges interest payments for another party’s cash flow. In this scenario, an investment bank underwrites a fixed-rate security. The bank and an investor then enter into a swap agreement, which typically expires before the security’s term reaches maturity. While the swap agreement is in effect, the investor owns the inverse floater.
Inverse floaters can be volatile and precarious. For example, when a short-term interest rate increases, the amount of interest paid on an inverse floater bond typically decreases. As a result, the bond’s price may drop substantially. For the bond holder, this usually means that little interest is generated from the bond. In addition, the bond will likely realize a lower market value.