What is a floating-rate note (FRN)?
A floating-rate note (FRN) is a variable-rate debt. FRN interest rates are benchmarked. Benchmarks entail the U.S. Treasury note rate, Fed funds rate, LIBOR, or prime rate.
Financial institutions, governments, and businesses all issue floating-rate notes (floaters) for two to five years.
Understanding FRNs
Much of the U.S. investment-grade bond market is floating-rate notes (FRNs). Since floaters adapt to market rates, investors profit from rising interest rates more than fixed-rate debt instruments. Floaters are typically compared to short-term rates, such as the Fed funds rate, established by the Federal Reserve Bank for bank borrowing.
Bonds and U.S. Treasury products often pay investors more as maturity approaches. The increasing yield curve rewards investors for keeping longer-term securities. In other words, a 10-year bond should yield more than a two-month bond under typical market circumstances.
Since floating-rate notes are benchmarked to short-term rates, investors receive a lower yield than fixed-rate notes. The investor sacrifices some yield for the assurance of a rising benchmark rate. Should the short-term benchmark rate decline, so will the FRN rate.
FRN rates may not climb as rapidly as interest rates in a rising-rate scenario. Everything depends on benchmark rate performance. FRN bondholders may face interest rate risk if the bond’s rate falls below the market average.
Since the bond’s rate may change due to market conditions, FRN prices are less volatile. Traditional fixed-rate bonds fall as rates rise because bondholders lose out by keeping a lower-rate instrument.
FRNs reduce market price volatility because bondholders have less opportunity cost in rising-rate markets. FRNs are subject to default risk, like any bond, if the firm or government can’t repay the investor’s principal.
Since floaters have changeable rates, coupon payments are uncertain. A coupon payment is the interest payment on a bond. Floaters with caps and floors let investors know the note’s maximum and minimum interest rates.
FRN interest rates might alter daily or annually at the issuer’s discretion. The reset period in the bond prospectus shows investors how often the rate changes. Interest may be paid monthly, quarterly, semiannually, or annually.
Non-callable vs. callable floating rate notes
With or without a callable option, FRNs allow the issuer to refund the investor’s principal and discontinue interest payments. An upfront callable feature lets the issuer pay off the bond before maturity.
Pros
- Floating rate notes benefit investors from rising rates as the FRN responds to the market.
- Price fluctuations affect FRNs less.
- U.S. Treasury bonds and corporate bonds provide FRNs.
Cons
- FRNs may face interest rate risk if market rates rise more than rate resets.
- If the issuing firm can’t repay the principal, FRNs may default.
- If market interest rates decrease, FRN rates may too.
- The FRN rate is usually lower than the fixed-rate rate.
Floating Rate Note Example
The Treasury Department issued floating-rate notes in 2014. Note traits and requirements:
- The $100 minimum purchase
- Two-year maturity
- At maturity, the investor gets the note’s face value.
- Pays a variable rate based on a 13-week Treasury bill.
- Quarterly interest or coupon payments
- FRNs can be sold before or after maturity.
- Electronically issued
- The federal income tax applies to interest.
Conclusion
- Fixed-rate notes have a fixed interest rate, whereas floating-rate notes have a variable rate.
- A short-term benchmark rate like LIBOR or the Fed funds rate and a stated spread, or stable rate, determine the interest rate.
- Quarterly coupons are common on floating-rate notes, but others pay monthly, semiannually, or annually.
- Investors like FRNs because the floater rate adjusts to market rates, giving them excellent interest rates.
