A floating-rate security also known as a “floater”, is an investment with interest payments that float or adjust periodically based upon a predetermined benchmark. While floaters may be linked to almost any benchmark and pay interest based on a variety of formulas, the most basic type pays a coupon equal to some widely followed interest rate or a change in a given index over a defined time period[1]. Floating rate securities have a coupon rate or interest rate that varies based on a short-term rate index. While this is more complex than fixed coupons, floating rates are generally advantageous for lenders when interest rates are rising. Just like fixed-rate notes, floating-rate notes can be callable or non-callable, which means that the issuer may have the option to repay the principal before the maturity date is reached. Floating-rate notes may also have what’s known as a “cap” or “floor.” A cap is a maximum interest rate the note can pay, regardless of how high the benchmark rate climbs, and a floor is the lowest allowable payment.

Features of a FRN

Like other interest rate securities, floating rate notes share similar characteristics and features. FRNs commonly have an issuer, face values, interest coupons, coupon frequencies and yields, however, certain features of FRNs make them unique. The paper highlights the following features:

1. Floating interest rate: Traditional bonds characteristically have a fixed coupon rate that is determined upon issuance. However, have coupon payments thar vary, or “float,” in accordance with prevailing market interest rates. Because the coupon rate mirrors the market rate, floating-rate bonds exhibit minimal price sensitivity to changes in interest rate levels.
2. Capital structure seniority: Floating-rate loans, as opposed to typical debt offerings, are not issued by a firm directly to the public. Instead, banks and similar financial institutions extend loans to firms in need of raising capital. These loans, much like mortgages or other private loans, are then repackaged for sale to investors.
3. Borrower credit quality: Floating-rate loans most commonly serve as an alternative source of financing for companies whose credit quality is rated below-investment-grade, or “junk.” These companies may find it comparatively more difficult or costly to access credit in the capital markets, such as fixed interest rate bonds.
4. Low interest rate risk: Floating-rate funds, by design, curtail the effects of the former, as such, prices of these bonds are not expected to significantly respond to interest rate fluctuations.
5. High credit risk: However, the magnitude of the credit risk incurred with floating-rate funds is much greater than that for money market and short-term bond funds. This is because floating-rate funds invest in below-investment-grade loans, whereas money market and short-term bond funds invest in high-quality securities.

Shariah Non-compliance Issues

In commenting on the Sharia non-compliance issues in floating rate notes, the paper highlights that floating rate notes and bonds are debt instruments which pay investors interest. The AAOIFI Sharia Standard No.21 expounds on the rulings of bonds and notes issuance and states:

“The issuance of all kinds of bonds is prohibited when these bonds include stipulations for the return of the amount of loan and excess in any form, whether such excess is paid at the time of the satisfaction of the principal amount of loan, is paid in monthly or yearly instalments or in another manner and whether this excess represents a percentage of the value of the bond, as in the case with most types of bonds, or a part of it, as is the case with zero-coupon bonds. Likewise, prize bonds are also prohibited. This applies irrespective of the bonds being private, public or governmental.”

The paper presents a floating-rate Ijara Sukuk as alternative to FRNs. Sukuk is a financial instrument that shares characteristics with bond and stock which are issued to finance trade or the production of tangible assets. Similar to a bond, Sukuk has a maturity date and in some of them the holder will receive a regular income over the period and a final payment at the maturity date. While the conventional bonds price is determined only by the creditworthiness of the issuer, Sukuk price is determined by the creditworthiness of the issuer and the value of the asset. Although Sukuk is also similar to stocks in the sense that it represents ownership and no guarantee of a fixed return (at least theoretically and in the standard model of Sukuk) but stocks have no maturity date. Sukuk also have to relate to a specific asset, project or service.

Alternative Instrument

An alternative to floating rate notes is the floating rate Ijarah Sukuk. Ijarah sukuk is based on the Ijarah contract. In order to issue Ijarah sukuk, the originator, who primarily owns the assets, sells the assets to an SPV (Special Purpose Vehicle), which is typically a company in an offshore tax‐free site. The SPV leases the assets back to the issuer at a specific predetermined rental fee, and then the SPV securitises the ownership in the assets by issuing Sukuk certificates to the public investors. These Sukuk certificates represent an undividable share in the ownership of the assets, which entitles the Sukuk holders to distribution of the rental payments on the underlying assets. However, the rental payment could be fixed or floating for the whole period, depending on the leasing contract between the SPV and the originator. Since these Sukuk certificates represent ownership in real assets, they can be traded in a secondary market. The Sukuk certificate holder owns part of the underlying asset or usufructs and earns floating rent indexed to a market benchmark.

[1] Raymond Hames, A Guide to Understanding Floating Rate Securities, Available from: https://www.raymondjames.com/wealth-management/advice-products-and-services/investment-solutions/fixed-income/fixed-income-strategies/a-guide-to-understanding-floating-rate-securities