Refers to a debt security whose value increases as interest rates rise, i.e. there is a direct price-yield relationship rather than the usual inverse price-yield relationship. In this context, one example of an inverse floater is an IO, the interest-only component of an MBS strip. As interest rates rise, people are less likely to refinance their mortgages, meaning the existing principal in a mortgage pool is more likely to remain intact. In turn, the cash flows on the IOs are more likely to continue. Therefore, as interest rates rise, the IO becomes more valuable, and so its price rises..
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Inverse Floating-Rate Note
A bond or other debt security with a variable coupon rate that changes in inverse proportion to some benchmark rate. For example, an inverse floating-rate note may be linked to LIBOR; as the LIBOR decreases, the coupon rate increases and vice versa. An inverse floating-rate note allows a bondholder to benefit from declining interest rates. It is also called an inverse floater.
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A derivative security that has a yield that is inversely related to interest rates. Inverse floaters are one part of a long-term bond. A portion of the bond's current interest income is used to pay money market rates to holders of the regular floating-rate notes. The remainder of current interest and changes in the bond's market value are earned by holders of the inverse floaters. Holders of this type of security can have major losses as a result of increases in interest rates. These securities are used primarily, although not always successfully, by professional portfolio managers.
Wall Street Words: An A to Z Guide to Investment Terms for Today's Investor by David L. Scott. Copyright © 2003 by Houghton Mifflin Company. Published by Houghton Mifflin Company. All rights reserved. All rights reserved.