Flip-Flop Note: What It is, How It Works, Example

What is Flip-Flop Note?

Flip-flop note is a fixed-income security, backed by two different sources of debt - one with a fixed interest rate and the other with a variable interest rate, that allows the holder to choose their payment stream.

Understanding Flip-Flop Note

A flip-flop note acts like an embedded option for investors. In other words, the holder of the flip-flop note may choose between a variable interest rate and a fixed interest rate, whichever has a higher yield for the period.

All flip-flop notes are technically debt securities which are packed by two debt types. The variable interest rate is a rate on a loan or security which fluctuates over time because of its basis on an underlying benchmark or index that changes periodically. The fixed interest rate security pays a specified rate of interest that does not change over the life of the instrument. As with any other fixed-income security, the face value of the flip-flop note is returned to the investor when the security reaches it's maturity date.

Most flip-flop notes will limit when the holder gets to choose which interest rate is the basis for their interest payments.to specific dates. Flip-flopping between the two rates allows the holder to earn income from the interest rate based on which type of debt is yielding more interest at the moment.

According to the Dictionary of Financial Risk Management, a flip-flop note can also let the borrower shorten or lengthen the term of the note based on the kind of opportunities that are available on the note reset date. This feature means the borrower does not get to choose the change in the interest rate based on a whim. Instead, it must happen when the bond’s reset date is up. When the reset date comes, the investor has the option to choose to lengthen or shorten the term of the investment, whether it’s a bond or a note, based on the current interest rates.

Flip-Flop Note Example

For example, a typical flip-flop note could be comprised of a fixed-rated debt and a floating-coupon bond. If the floating interest rate drops below the fixed coupon, the investor can choose to receive income from the fixed-rate debt. Conversely, when the floating rate exceeds the fixed coupon, the investor would switch to the floating-rate debt for income. In this situation, the flip-flop note is similar to a floating-rate bond with an interest rate floor.

A flip-flop note could also allow an investor to switch between two types of securities for their investment. For example, a flip-flop note could be used to switch from a long-term bond to a short-term fixed-rate note or fixed security. In some cases, a flip-flop note can also be used to switch from notes to equities.