Questions: Floating Rate Bonds and Variable-Coupon Debt

Question 1

Interest rates rise sharply from 3% to 5%. An investor holds two bonds with identical maturity and credit quality: one fixed-rate at 3% coupon, one floating-rate at benchmark + 0.5%. What happens to each bond's price?

• A. Both fall in price — rising rates hurt all bond prices equally
• B. The fixed-rate bond falls in price; the floating-rate bond's price stays near par
• C. The floating-rate bond falls more — it has higher payment uncertainty
• D. The fixed-rate bond falls; the floating-rate bond falls less because the spread provides a cushion

Answer: (B)

The fixed-rate bond locks in 3% coupons, now below market — investors demand a discount. The floating-rate bond resets its coupon to 5.5% at the next reset date, so both the cash flows and the discount rate rise together, keeping present value roughly constant. Option A is wrong because floaters are specifically designed to avoid price decline. Option D is wrong — the spread doesn't 'cushion' anything; the reset mechanism eliminates the interest rate sensitivity almost entirely.

Question 2

Why is a floating-rate bond's effective duration approximately equal to the time until the next coupon reset, rather than the bond's full maturity?

• A. Because floating-rate bonds are always short-term instruments that mature quickly
• B. Because the benchmark rate determines the bond's maturity date
• C. Because at each reset the bond reprices to market — between resets it behaves like an ultra-short-term instrument maturing at the next reset date
• D. Because the fixed spread dominates the duration calculation

Answer: (C)

Duration measures price sensitivity to rate changes. A floater reprices to par at each reset because it pays what the market requires at that moment. Between resets it is essentially a fixed-rate bond maturing at the next reset date — days or weeks away — which has negligible price sensitivity. Option A is wrong; floaters can have long legal maturities of 10 or 20 years. Option B is nonsensical. Option D is backwards — the spread is fixed and small; it's the variable benchmark component that drives near-zero duration.

Question 3

A floating-rate bond's price stays near par when market interest rates rise because its coupon payments increase proportionally, keeping the bond's present value roughly constant.

• T. True
• F. False

Answer: True

This is the core mechanism. Bond price equals the present value of future cash flows. For a fixed-rate bond, the numerators (cash flows) are fixed while the denominator (discount rate) rises — price falls. For a floater, both the numerators and denominator rise together, so the ratio (present value) stays approximately constant. This isn't an approximation of why floaters work — it is the fundamental reason they were invented.

Question 4

An investor in a floating-rate bond faces no meaningful price risk as long as market interest rates remain stable.

• T. True
• F. False

Answer: False

Even with stable interest rates, a floater faces credit spread risk. The coupon resets to benchmark + fixed spread. If the issuer's creditworthiness deteriorates, the market demands a wider spread — but the fixed spread in the coupon formula doesn't change. The bond's price falls to reflect inadequate compensation for the now-higher credit risk. This is often overlooked: rates can be perfectly stable while the issuer's credit quality erodes, causing the floater's price to decline just as a fixed-rate bond would in a rising-rate environment.

Question 5

Explain why a floating-rate bond's price stays near par even as market interest rates change significantly over the bond's lifetime.

Model answer: A floater's coupon resets to the current benchmark at each reset date. Because cash flows adjust proportionally with the discount rate used to price them, the present value remains approximately constant. Between resets the bond behaves like an ultra-short-term instrument maturing at the next reset date, which has minimal price sensitivity. At each reset, the bond reprices back to par by definition — the investor is effectively rolling over a very short-term instrument at current market rates.

The key is effective duration: a floater's price sensitivity is determined by the time to next reset (days to weeks), not its legal maturity. This is the designed property of the instrument — issuers and investors both use it specifically to decouple income from capital value. The near-zero price sensitivity holds as long as we're talking about interest rate risk; credit spread risk, which floaters do not eliminate, is a separate and often underappreciated exposure.