Inverse Floaters

Inverse Floater

Explained:

An inverse floater (or reverse floater) is a floater whose coupon fluctuates inversely with its reference rate—increasing when the reference rate decreases and decreasing when the reference rate increases. With each coupon payment, the floating rate is reset for the next period according to the formula:

floating rate = fixed rate – coupon leverage

reference rate

[1]

The multiplier is called the coupon leverage. Often, it is equal to 1, but not always. If it exceeds 1, the instrument is called a leveraged inverse floater.

Inverse floaters have been issued by corporations or government-sponsored enterprises as intermediate-term notes. A typical structure might have a maturity of five years, pay interest quarterly, and offer a floating rate of 12% minus two times a reference rate of 3-month USD Libor. There might also be a cap and/or floor for the floating rate.

Collateralized mortgage obligations (CMOs) are sometimes structured as inverse floater tranches called inverse floater CMOs. If collateral is fixed rate mortgages, offsetting floater and inverse floater tranches are paired. In this way, fixed coupons are split into floating and inverse floating coupons.

Market values of floaters tend to be unstable. Their durations are typically very high. They have in the past been popular with investors who wanted to bet on a decline in interest rates.

During the 1990s, inverse floaters gained a bad reputation. Money market funds are typically restricted to investing in money market instruments with maturities under a year. Many make an exception for floaters with maturities in excess of a year because these have durations under a year. Managers of some money market funds used this as a loophole and invested in inverse floaters as a way to bet on the direction of interest rates. When those bets went bad, the funds incurred losses not typical of money market funds. Several affected fund companies stepped in and made up the losses with their own money. It is unlikely they will let the same thing happen again.