An inverse floating rate note, or simply an inverse floater, is a type of bond or other type of debt instrument used in finance whose coupon rate has an inverse relationship to short-term interest rates (or its reference rate). With an inverse floater, as interest rates rise the coupon rate falls.[1] The basic structure is the same as an ordinary floating rate note except for the direction in which the coupon rate is adjusted. These two structures are often used in concert.
As short-term interest rates fall, both the market price and the yield of the inverse floater increase. This link often magnifies the fluctuation in the bond's price. However, in the opposite situation, when short-term interest rates rise, the value of the bond can drop significantly, and holders of this type of instrument may end up with a security that pays little interest and for which the market will pay very little. Thus, interest rate risk is magnified and contains a high degree of volatility.[2]
^Inverse Floater, Investopedia.com, Retrieved on March 20, 2008
^Inverse Floaters and the Income Stability of a Debt Securities Investment Portfolio[permanent dead link], Wharton - Insurance Risk Management, Retrieved on March 20, 2008
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