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What Is a Floating Rate Note?

A floating rate note (FRN) is a debt security with a variable interest payment, meaning its coupon rate adjusts periodically based on a predetermined benchmark rate. This characteristic places FRNs within the broader category of fixed-income instruments, specifically those designed to offer dynamic returns. Unlike traditional bonds that offer a fixed coupon rate for their entire duration, a floating rate note's interest payments "float" or change in response to market conditions. This allows the interest received by investors to adjust to prevailing interest rates, potentially offering protection against rising rates. Floating rate notes are often issued by governments, corporations, and financial institutions as a means of raising capital.

History and Origin

Floating rate notes originated in Europe and first appeared in the United States in 1974 with a significant issuance by Citicorp.16 Initially, their popularity fluctuated, but market conditions, particularly rising interest rates in the late 1970s, revived their attractiveness.15 The U.S. Treasury Department introduced its first floating rate notes in 2014, marking the first new marketable Treasury security since Treasury Inflation-Protected Securities (TIPS) in 1997.14 This introduction aimed to broaden the Treasury's portfolio and investor base, as FRNs offer less exposure to rising rates due to frequent rate resets.13

Key Takeaways

  • A floating rate note (FRN) is a type of debt security whose interest payments fluctuate based on a benchmark rate plus a spread.
  • FRNs are designed to mitigate interest rate risk for investors, as their coupon rates adjust to current market conditions.
  • The interest rate for an FRN is typically reset at predetermined intervals, such as quarterly, and is linked to a money market reference rate.
  • While offering price stability, FRNs may yield less initially than comparable fixed-rate notes when the yield curve is upward sloping.
  • Issuers, including governments and corporations, use FRNs to manage borrowing costs and attract investors seeking protection against rising interest rates.

Formula and Calculation

The interest rate for a floating rate note is typically calculated as a benchmark rate plus a specified spread. The spread is a fixed percentage or basis points that remains constant over the life of the note, compensating investors for the credit risk of the issuer.

The coupon payment for a period can be expressed as:

Coupon Rate=Reference Rate+Quoted Spread\text{Coupon Rate} = \text{Reference Rate} + \text{Quoted Spread}

Where:

  • Reference Rate: A variable market interest rate, such as the Secured Overnight Financing Rate (SOFR), the Federal Funds Rate, or historically, LIBOR. This rate is typically observed at the beginning of each coupon period.
  • Quoted Spread: A fixed number of basis points (bps) added to (or, less commonly, subtracted from) the reference rate. It reflects the issuer's creditworthiness and the market's required compensation above the reference rate.

For example, if the reference rate is 3% and the quoted spread is 50 basis points (0.50%), the coupon rate for that period would be 3.50%. The actual interest payment would then be calculated by applying this rate to the par value of the note for the duration of the period.

Interpreting the Floating Rate Note

Interpreting a floating rate note involves understanding its responsiveness to changes in the underlying benchmark interest rate. When market interest rates rise, the coupon payments on an FRN will also increase, offering investors potentially higher income. Conversely, if interest rates fall, the coupon payments will decrease. This mechanism allows the market price of FRNs to remain relatively stable compared to fixed-rate bonds, as the yield adjusts to prevailing rates, reducing significant price fluctuations due to interest rate movements.12 Investors seeking to mitigate interest rate risk often find floating rate notes appealing, especially in environments where interest rates are expected to rise.11

Hypothetical Example

Consider an investor purchasing a floating rate note with a par value of $1,000. The note pays quarterly interest, and its rate is set at the 3-month SOFR plus a spread of 0.75%.

  1. Quarter 1 (January-March): At the beginning of January, the 3-month SOFR is 4.00%. The coupon rate for this quarter is 4.00% + 0.75% = 4.75%.
    • Quarterly interest payment: $($1,000 \times 4.75%) / 4 = $11.875$.
  2. Quarter 2 (April-June): At the beginning of April, the 3-month SOFR has risen to 4.50%. The new coupon rate is 4.50% + 0.75% = 5.25%.
    • Quarterly interest payment: $($1,000 \times 5.25%) / 4 = $13.125$.
  3. Quarter 3 (July-September): At the beginning of July, the 3-month SOFR drops to 4.20%. The coupon rate adjusts to 4.20% + 0.75% = 4.95%.
    • Quarterly interest payment: $($1,000 \times 4.95%) / 4 = $12.375$.

This example demonstrates how the interest payments from the floating rate note fluctuate with changes in the benchmark rate, providing dynamic income to the investor throughout the note's term to maturity date.

Practical Applications

Floating rate notes are widely used across various sectors of the bond market. Governments, such as the U.S. Treasury, issue FRNs to diversify their funding sources and appeal to investors seeking protection from rising interest rates.10 Corporations and financial institutions are also common issuers of FRNs. For instance, companies like Morgan Stanley issue fixed-to-floating rate notes, which start with a fixed rate and then convert to a variable rate based on a benchmark like LIBOR or the Consumer Price Index (CPI) plus a spread.9,8

Investors incorporate FRNs into their portfolios for several reasons:

  • Interest Rate Hedging: FRNs are particularly useful for investors looking to hedge against rising interest rates. As the benchmark rate increases, the interest payments on the FRN will also increase, helping to offset potential declines in the value of fixed-rate holdings.7
  • Cash Management: Due to their frequent interest rate resets and relatively stable principal value, FRNs can be attractive for managing cash flows and maintaining liquidity.
  • Diversification: Including FRNs in an asset allocation strategy can enhance portfolio diversification by introducing an asset class with different sensitivities to interest rate movements compared to traditional fixed-rate bonds.

Limitations and Criticisms

While floating rate notes offer advantages, they also come with certain limitations and criticisms. One primary concern is that while FRNs provide greater price stability than fixed-rate bonds in a rising interest rate environment, their income payments will decrease if interest rates fall. This makes them less attractive in a declining rate environment.6

Another criticism revolves around their complexity, especially notes with embedded features like caps and floors. A "capped FRN" has a maximum limit on how high its coupon rate can rise, which protects the issuer but limits the investor's upside during sharp rate increases.5 Conversely, a "floored FRN" has a minimum interest rate, benefiting the investor by setting a lower bound on payments, but potentially at the cost of a lower initial spread.4 The presence of such features can make their valuation and behavior more intricate to understand for the average investor.

Furthermore, while U.S. Treasury FRNs are generally considered to have minimal credit risk, corporate FRNs are subject to the creditworthiness of their issuer. If the issuer's financial health deteriorates, there is a risk of default, similar to other corporate debt.3 Despite their design to reduce interest rate risk, FRNs are not entirely immune to price fluctuations, particularly during periods of extreme market volatility when rates may not reset quickly enough to prevent price changes.

Floating Rate Note vs. Fixed-Rate Bond

The primary distinction between a floating rate note (FRN) and a fixed-rate bond lies in how their interest payments are determined.

FeatureFloating Rate Note (FRN)Fixed-Rate Bond
Coupon RateVariable; adjusts periodicallyFixed; remains constant for the bond's life
Interest Rate RiskLower; price tends to be more stable as rates adjustHigher; price is inversely sensitive to interest rates
Income StreamFluctuates with market ratesPredictable and stable
Market Value StabilityGenerally more stable in varying rate environmentsMore volatile, especially with interest rate changes
Benefit in Rising Rate EnvironmentIncome payments increasePrice tends to decrease
Benefit in Falling Rate EnvironmentIncome payments decreasePrice tends to increase

Confusion often arises because both are debt instruments, but their interest payment mechanisms cater to different investor objectives and market outlooks. FRNs appeal to investors who anticipate rising interest rates or prioritize price stability, whereas fixed-rate bonds suit those seeking predictable income streams and who may benefit from falling interest rates.

FAQs

What is the primary benefit of investing in a floating rate note?

The main benefit of investing in a floating rate note is its ability to adjust its interest payments in response to changes in market interest rates. This feature helps protect investors from potential capital losses that fixed-rate bonds might experience when interest rates rise.

How often do floating rate notes reset their interest rates?

The frequency of interest rate resets for floating rate notes varies but is typically quarterly. However, some FRNs may reset daily, monthly, semi-annually, or annually, depending on the terms of the specific bond.2

Are floating rate notes considered less risky than fixed-rate bonds?

Floating rate notes generally carry less interest rate risk than fixed-rate bonds because their coupon payments adjust to current market rates, which helps stabilize their market price. However, they are still subject to other risks, such as credit risk (the risk of the issuer defaulting) and liquidity risk.

Can a floating rate note pay zero interest?

Some floating rate notes can have a "floor" that sets a minimum interest rate, often 0%.1 If the benchmark rate plus the spread falls below this floor, the interest paid would be the floor rate. Without a floor, in extreme scenarios where the benchmark rate becomes negative and the spread isn't large enough to offset it, the effective interest rate could theoretically approach or become zero, though this is rare for most standard FRNs.