Floating rate note

What Is Floating Rate Note?

A floating rate note (FRN) is a type of debt instrument within the broader category of fixed income securities. Unlike traditional bonds that pay a fixed coupon rate for their entire life, the interest payments on a floating rate note adjust periodically. This adjustment is tied to a specific benchmark rate, such as the Secured Overnight Financing Rate (SOFR) or a Treasury bill rate, plus a fixed spread. As the benchmark rate fluctuates, so do the interest payments received by the note holder. Floating rate notes are particularly attractive to investors who anticipate rising interest rates because they offer the potential for increased income over time.

History and Origin

While floating rate notes have been issued by corporations and government-sponsored enterprises for decades, their adoption by sovereign governments has varied. In the United States, the Department of the Treasury introduced its first marketable floating rate note on January 29, 2014. This marked the first new marketable debt instrument introduced by the U.S. Treasury since Treasury Inflation-Protected Securities (TIPS) in 1997.¹³ The decision to issue FRNs was driven by the Treasury's objectives to diversify its investor base, manage the maturity profile of the nation's outstanding debt, and finance government operations at the lowest possible cost over time.¹² Prior to this, the Treasury had considered FRNs as early as 1994, but initially chose to introduce only TIPS.¹¹ The new two-year FRN issued by the U.S. Treasury features quarterly interest payments, with rates indexed to the 13-week Treasury bill.¹⁰

Key Takeaways

• Floating rate notes (FRNs) are debt instruments with variable interest payments that adjust based on a benchmark rate plus a spread.
• They offer investors a hedge against rising interest rates, as coupon payments increase when the benchmark rate rises.
• FRNs typically have lower duration compared to fixed-rate bonds, making their prices less sensitive to interest rate changes.
• Issuers of FRNs include governments, financial institutions, and corporations.
• The U.S. Treasury began issuing its own FRNs in 2014 to diversify its debt offerings and investor base.

Formula and Calculation

The coupon payment for a floating rate note is determined by a simple formula: a chosen benchmark rate plus a fixed spread. This spread, also known as the quoted margin, remains constant throughout the life of the note. The benchmark rate, however, resets periodically, typically quarterly or weekly, depending on the specific terms of the FRN.

The interest rate for a given period can be expressed as:

$\text{Interest Rate} = \text{Benchmark Rate} + \text{Spread}$

For example, if the benchmark rate (such as the 3-month SOFR) is 4.50% and the note has a spread of 0.20%, the interest rate for that period would be 4.70%. This rate is then applied to the note's face value to calculate the actual interest payment. The yield on a floating rate note, particularly when considering market price, can also involve a discount margin calculation that adjusts for premiums or discounts in the secondary market.⁹

Interpreting the Floating Rate Note

Interpreting a floating rate note primarily involves understanding its variable nature and how it reacts to changes in the prevailing economic environment, particularly interest rate movements. When analysts or investors evaluate an FRN, they focus on two main components: the underlying benchmark rate and the fixed spread. The benchmark rate reflects current short-term market rates, while the spread represents the additional compensation an investor receives above that benchmark, often reflecting the issuer's credit risk. A higher spread might indicate a higher perceived risk of the issuer, requiring greater incentive for investors. Because the coupon adjusts, the market price of an FRN tends to be more stable than that of a fixed-rate bond when interest rates change, as the note's income stream automatically recalibrates.⁸ This characteristic makes FRNs particularly attractive in periods of rising interest rates, as they allow investors to participate in the upside of increasing rates without significant capital depreciation.

Hypothetical Example

Imagine an investor, Sarah, purchases a floating rate note with a face value of $1,000. The FRN pays interest quarterly and is tied to the 3-month SOFR (Secured Overnight Financing Rate) plus a spread of 0.25%.

• Quarter 1: The 3-month SOFR is 4.00%.

  • Interest Rate = 4.00% (SOFR) + 0.25% (Spread) = 4.25%
  • Quarterly Interest Payment = $1,000 * (4.25% / 4) = $10.63

• Quarter 2: The 3-month SOFR rises to 4.50% due to an increase in general interest rates.

  • Interest Rate = 4.50% (SOFR) + 0.25% (Spread) = 4.75%
  • Quarterly Interest Payment = $1,000 * (4.75% / 4) = $11.88

• Quarter 3: The 3-month SOFR drops to 3.80%.

  • Interest Rate = 3.80% (SOFR) + 0.25% (Spread) = 4.05%
  • Quarterly Interest Payment = $1,000 * (4.05% / 4) = $10.13

As this example illustrates, the interest payment on the floating rate note fluctuates with the benchmark rate, providing Sarah with higher payments when rates rise and lower payments when rates fall, all while maintaining the principal value at maturity.

Practical Applications

Floating rate notes are utilized in various facets of finance and investing, serving as key instruments for both borrowers and lenders. For investors, FRNs are a common tool for risk management in rising interest rate environments. They can be particularly appealing for those seeking to protect their bond portfolios from significant price declines that often affect fixed-rate securities when rates increase.⁷ U.S. Treasury FRNs, for instance, are issued in two-year maturities and pay interest quarterly, with their rate tied to the highest accepted discount rate of the most recent 13-week Treasury bills.⁶ These can be purchased directly from the U.S. government through TreasuryDirect.⁵

Corporations and financial institutions also issue floating rate notes to raise capital, often finding them attractive when short-term borrowing costs are low or when they want to match the variable rate of their assets (e.g., loans) with their liabilities. Furthermore, FRNs play a role in institutional portfolio management, where they can be used to manage liquidity and interest rate exposure.⁴ The Securities and Exchange Commission (SEC) provides guidance on understanding the characteristics and risks of floating rate notes, highlighting their function as fixed income securities with periodically resetting coupons.³

Limitations and Criticisms

Despite their advantages, floating rate notes are not without limitations. One primary criticism revolves around their performance in falling interest rate environments. While they offer protection against rising rates, their coupon payments will decrease when benchmark rates decline, leading to lower income for the investor.² This contrasts with fixed-rate bonds, which continue to pay a consistent coupon regardless of market rate shifts.

Another consideration is the potential for credit risk, particularly for FRNs issued by corporations or financial institutions, as the note's value is tied to the issuer's ability to make payments. Although U.S. Treasury FRNs carry minimal credit risk due to the backing of the U.S. government, other issuers may present varying degrees of default risk. Furthermore, while FRNs are generally less susceptible to interest rate risk in terms of price fluctuations, they do not offer the same fixed income stream predictability as fixed-rate instruments, which can be a drawback for investors prioritizing stable, predetermined cash flows. Some observers also note that the benefits of floating rate debt for investors come at a cost to the issuer, as their borrowing expenses rise with increasing rates, making it less attractive for high-rated entities to issue them unless market conditions demand it.¹

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. A fixed-rate bond pays a constant, predetermined interest rate over its entire life, providing predictable income for the investor. In contrast, a floating rate note has a variable interest rate that adjusts periodically based on a benchmark rate plus a set spread.

This fundamental difference leads to varied behaviors in different interest rate environments. Fixed-rate bonds are highly sensitive to changes in prevailing interest rates; their market value typically falls when interest rates rise and increases when rates fall. This is due to their fixed income stream becoming less or more attractive relative to new market rates. Floating rate notes, conversely, exhibit less price volatility in response to interest rate changes because their coupon payments adjust to reflect current market conditions. When rates rise, the FRN's coupon payments increase, helping to preserve its market value, and when rates fall, the payments decrease. Investors often choose FRNs for capital preservation and income increases during periods of expected rising rates, whereas fixed-rate bonds are preferred for stable income and potential capital appreciation when rates are expected to fall or remain stable.

FAQs

Q1: Why would an investor choose a floating rate note over a fixed-rate bond?

An investor would typically choose a floating rate note (FRN) when they anticipate that interest rates are likely to rise. Because the FRN's interest payments adjust upwards with increasing benchmark rates, it allows the investor to earn more income and helps protect the note's market value from the declines often seen in fixed-rate bonds during rising rate environments.

Q2: What is the "spread" in a floating rate note?

The "spread" in a floating rate note is a fixed percentage added to the variable benchmark rate to determine the actual interest payment. This spread remains constant for the life of the note and reflects the creditworthiness of the issuer, as well as market demand for that particular floating rate note.

Q3: Are U.S. Treasury Floating Rate Notes safe investments?

U.S. Treasury Floating Rate Notes (FRNs) are generally considered among the safest investments because they are backed by the full faith and credit of the U.S. government, implying minimal credit risk. While their interest payments fluctuate, the principal investment is highly secure. They also offer a way to participate in rising interest rates, similar to continuously rolling over Treasury bills but with longer maturities.