Floating rate notes frns

What Is Floating Rate Notes (FRNs)?

Floating rate notes (FRNs) are a type of debt security belonging to the broader category of fixed-income securities. Unlike traditional bonds that pay a fixed interest rate for their entire life, FRNs have a variable coupon that resets periodically. The interest rate on an FRN is typically tied to a short-term benchmark rate, such as the Secured Overnight Financing Rate (SOFR), plus a fixed spread. This mechanism allows the coupon payments to adjust in line with prevailing market interest rates, offering investors a hedge against rising rates. FRNs can be issued by governments, corporations, and financial institutions.⁴⁴

History and Origin

The concept of floating rate notes emerged in Europe and first appeared in the United States in 1974. One notable early issuance in the U.S. occurred when Citicorp sold $650 million worth of fifteen-year notes, making it one of the largest floating rate issues at that time. These early FRNs often had an initial fixed rate for a short period, after which they would float based on a benchmark, such as the three-month United States Treasury bills rate.⁴³

Initially, the attractiveness of floating rate notes fluctuated with market conditions, seeing a resurgence in popularity around 1978 and 1979 amidst predictions of rising interest rates and an inverted yield curve.⁴² In more recent history, the U.S. Treasury officially introduced its own Floating Rate Note program in 2013, marking the first new marketable Treasury securities since Treasury Inflation-Protected Securities (TIPS) in 1997. The first auction for a U.S. Treasury FRN was held on January 29, 2014, following an amendment to the Uniform Offering Circular on July 31, 2013, to accommodate their issuance.⁴⁰, ⁴¹

Key Takeaways

• Floating rate notes (FRNs) are debt securities with variable interest rates that reset periodically, typically quarterly.
• Their coupon rate is linked to a benchmark rate (like SOFR) plus a fixed spread determined at issuance.
• FRNs generally offer protection against rising interest rates, as their coupon payments increase when benchmark rates rise.³⁸, ³⁹
• They typically have shorter maturities, often ranging from two to five years, and tend to exhibit less price volatility compared to fixed-rate bonds in a changing interest rate environment.³⁶, ³⁷
• While offering benefits in rising rate environments, FRNs usually come with lower initial yields compared to fixed-rate debt securities of similar maturities.³⁴, ³⁵

Formula and Calculation

The interest rate for a Floating Rate Note (FRN) is determined by adding a fixed spread to a prevailing benchmark rate. The coupon payment for a period is then calculated based on this rate and the note's par value.

The formula for the interest rate of an FRN is:

Where:

• Benchmark Rate: A widely recognized money market reference rate, such as the Secured Overnight Financing Rate (SOFR) or the yield of a 13-week Treasury bills auction.³³ This rate fluctuates.
• Spread: A fixed rate (often expressed in basis points) that is added to the benchmark rate. This spread is determined at the time of the FRN's issuance and generally remains constant over the life of the note. It compensates investors for the credit risk of the issuer.³²

For example, if a 3-month SOFR is 4.50% and the spread is 0.25%, the FRN's interest rate for that period would be 4.75%. This rate is applied to the note's par value to determine the actual coupon payment.

Interpreting the Floating Rate Note (FRN)

Understanding an FRN involves observing its coupon rate, which is not static but dynamically adjusts to market conditions. The key to interpreting an FRN lies in recognizing its two components: the fluctuating benchmark rate and the constant spread. The spread reflects the issuer's credit risk; a wider spread typically indicates a higher perceived risk of default.³⁰, ³¹

Investors interpret FRNs primarily as instruments designed to provide income that keeps pace with changes in general interest rates. When benchmark rates rise, the income generated by an FRN increases, which can make it attractive in an inflationary or rising rate environment. Conversely, if benchmark rates decline, the coupon payments from an FRN will also decrease, potentially reducing the investor's income. This makes FRNs particularly appealing for investors who anticipate rising rates or seek to mitigate the negative impact of rate increases on their fixed-income securities portfolio.²⁸, ²⁹

Hypothetical Example

Consider an investor, Sarah, who buys a corporate floating rate note with a par value of $1,000. The FRN has a quarterly reset period, and its coupon rate is set at 3-month SOFR plus a spread of 0.30% (30 basis points).

1. Quarter 1: At the beginning of the first quarter, the 3-month Secured Overnight Financing Rate (SOFR) is 5.00%.

   • The FRN's interest rate for Quarter 1 would be (5.00% + 0.30% = 5.30%).
   • The annual interest payment would be ( $1,000 \times 0.0530 = $53.00 ).
   • The quarterly coupon payments would be ( $53.00 / 4 = $13.25 ).

2. Quarter 2: At the beginning of the second quarter, the 3-month SOFR increases to 5.50%.

   • The FRN's interest rate for Quarter 2 would be (5.50% + 0.30% = 5.80%).
   • The annual interest payment would be ( $1,000 \times 0.0580 = $58.00 ).
   • The quarterly coupon payments would be ( $58.00 / 4 = $14.50 ).

3. Quarter 3: At the beginning of the third quarter, the 3-month SOFR decreases to 4.80%.

   • The FRN's interest rate for Quarter 3 would be (4.80% + 0.30% = 5.10%).
   • The annual interest payment would be ( $1,000 \times 0.0510 = $51.00 ).
   • The quarterly coupon payments would be ( $51.00 / 4 = $12.75 ).

This example illustrates how the interest rates and subsequent coupon payments of the floating rate note adjust with changes in the underlying benchmark rate, offering Sarah varying income throughout the year.

Practical Applications

Floating rate notes are widely used in various financial contexts due to their adaptable nature. In investing, they are often sought by investors looking to hedge against rising interest rates, as their yields increase when benchmark rates climb. This makes FRNs attractive for managing a diversified portfolio, particularly in periods of anticipated rate hikes.²⁷ They can be issued by the U.S. government, such as two-year Treasury FRNs, as well as by corporations, banks, and government-sponsored enterprises.²⁶ Corporate FRNs, especially those considered investment-grade, can offer exposure to corporate credit with potentially less duration risk than long-term fixed-rate bonds.²⁴, ²⁵

In portfolio management, FRNs are utilized to reduce interest rate sensitivity. Because their coupon rates reset periodically, the market price of FRNs tends to remain more stable than that of fixed-rate bonds when interest rates fluctuate.²³ This characteristic helps investors avoid significant capital gains or losses on the bond's principal value due to rate changes, shifting the risk from price volatility to variable income. The market for FRNs has grown significantly, with U.S. Treasury FRN issuance increasing from $15 billion in 2014 to $657 billion by March 2025, comprising about 2.30% of total marketable U.S. Treasury debt.²²

Limitations and Criticisms

While floating rate notes offer advantages, they also come with certain limitations and criticisms. A primary drawback is that FRNs typically offer lower initial yields compared to fixed-rate bonds of similar maturity and credit quality. This is the trade-off for the protection they offer against rising interest rates.²⁰, ²¹ If interest rates decline, the coupon payments on an FRN will also fall, leading to lower income for the investor and making them less attractive than fixed-rate instruments that have locked in a higher return.¹⁸, ¹⁹

FRNs are not entirely immune to interest rate risk. In environments of extreme interest rate volatility, the rate resets may not occur quickly enough to fully prevent price fluctuations. Additionally, while often considered less sensitive to interest rate changes, FRNs can still experience market price volatility, potentially leading to capital losses if sold before maturity.¹⁷

Another significant concern is credit risk. While U.S. Treasury FRNs carry minimal credit risk due to government backing, corporate or bank-issued FRNs are subject to the creditworthiness of the issuer. Deterioration in an issuer's credit rating can lead to a widening of the spread and a decrease in the FRN's market value.¹⁵, ¹⁶ Furthermore, some FRNs may include a call provision, which allows the issuer to redeem the note before its stated maturity, often when interest rates decline. This can expose investors to reinvestment risk, as they may have to reinvest their principal at a lower prevailing rate.¹⁴ The variable nature of FRNs can also make them more complex for some investors to understand and analyze, and they may have lower liquidity risk compared to more actively traded fixed-rate bonds.¹², ¹³ Charles Schwab highlights these trade-offs, noting that while floaters provide price stability when yields are rising, they do not offer the same potential for price appreciation that fixed-rate bonds might enjoy when interest rates fall.¹¹

Floating Rate Notes vs. Fixed-Rate Bonds

Floating rate notes (FRNs) and fixed-rate bonds represent two fundamental types of debt securities, distinguished primarily by how their interest payments are structured. A fixed-rate bond pays a constant coupon payment throughout its life, providing predictable income to the investor. This predictability is a key appeal for those seeking stable cash flows. However, the market price of fixed-rate bonds is inversely related to changes in interest rates; if rates rise, the bond's price typically falls to make its fixed yield competitive with new, higher-yielding issues.¹⁰

In contrast, floating rate notes have a variable coupon that resets periodically, usually quarterly, based on a specified benchmark rate plus a fixed spread. This structure means that as market interest rates rise, the FRN's coupon payments will also increase, allowing the investor's income to keep pace.⁹ This adaptability makes FRNs less sensitive to interest rate fluctuations in terms of their principal value, as the interest rate adjustments tend to keep their market price closer to par.⁷, ⁸ The main confusion often arises from their respective sensitivities to interest rate environments: fixed-rate bonds offer stability of income but price volatility in a changing rate environment, whereas FRNs offer income variability but greater price stability. While FRNs offer protection against rising rates, they typically start with lower initial yields compared to fixed-rate counterparts and their income will decrease if rates fall.⁵, ⁶

FAQs

Q1: Why would an investor choose a floating rate note over a fixed-rate bond?
A1: An investor would typically choose a floating rate note if they anticipate rising interest rates or want to protect their portfolio from the negative impact of rate increases. FRNs provide variable coupon payments that adjust upwards as benchmark rates rise, helping to maintain the purchasing power of their income.⁴

Q2: Are floating rate notes considered safe investments?
A2: The safety of floating rate notes depends heavily on the issuer's credit risk. U.S. Treasury FRNs are considered very safe because they are backed by the full faith and credit of the U.S. government. Corporate FRNs, however, carry the risk of the issuing company defaulting, similar to other corporate bonds.³

Q3: How often do the interest rates on FRNs reset?
A3: The reset frequency for floating rate notes can vary, but it is most commonly quarterly. Some FRNs may reset daily, weekly, or annually, depending on the specific terms of the note. For example, U.S. Treasury FRNs reset weekly based on the 13-week Treasury bills auction rate.¹, ²