What Is a Floating-Rate Note (FRN)?
Let me explain what a floating-rate note, or FRN, really is. It's a debt instrument where the interest rate varies, tied directly to a benchmark rate. You might see benchmarks like the U.S. Treasury note rate, the Fed funds rate, LIBOR, or the prime rate.
These floating rate notes, often called floaters, get issued by financial institutions, governments, and corporations, usually with maturities between two and five years.
Key Takeaways on FRNs
An FRN is essentially a bond with a variable interest rate, unlike a fixed-rate note where the rate stays constant. The interest ties to a short-term benchmark like LIBOR or the Fed funds rate, plus a fixed spread that doesn't change.
Many FRNs pay interest quarterly, so you get payments four times a year, though some might do it monthly, semiannually, or annually. Investors like FRNs because they let you gain from higher interest rates as the floater's rate adjusts to current market conditions.
Understanding Floating Rate Notes (FRNs)
FRNs form a big part of the U.S. investment-grade bond market. Compared to fixed-rate debt, they let you benefit from interest rate increases since the rate adjusts periodically to match the market. They're typically benchmarked to short-term rates like the Fed funds rate, which the Federal Reserve sets for interbank borrowing.
Normally, the yield on bonds or Treasuries rises with longer maturities to compensate for holding them longer. That's why, under standard conditions, a 10-year bond pays more than a two-month one. FRNs usually yield less than fixed-rate options because they're tied to short-term rates—you trade some yield for the security of rates that can rise with the benchmark.
But if the benchmark falls, your FRN rate drops too. There's no assurance the FRN rate will keep up with overall interest rates in a rising environment; it depends on the benchmark's performance. This means you could still face interest rate risk if the bond underperforms the market.
Because the rate adjusts to conditions, FRN prices show less volatility. Fixed-rate bonds often drop when rates rise, as holders miss out on better returns. FRNs reduce that opportunity cost in rising markets, though they're still at risk of default if the issuer can't repay the principal.
With variable rates, coupon payments on floaters are unpredictable. A coupon is just the interest payment on the bond. Some FRNs include a cap and floor, so you know the max and min rates. The rate can reset as often as the issuer sets—from daily to yearly—and that's detailed in the prospectus. Interest might pay out monthly, quarterly, semiannually, or annually.
Callable Floating Rate Note vs. Non-Callable Floating Rate Note
FRNs can come with or without a callable option. If callable, the issuer can return your principal and stop interest payments before maturity. This feature is stated upfront and lets the issuer redeem the bond early.
Pros of Floating Rate Notes
- They let you benefit from rising rates as the FRN adjusts to the market.
- They're less affected by price volatility.
- You can find them in U.S. Treasuries and corporate bonds.
Cons of Floating Rate Notes
- You might still have interest rate risk if market rates outpace the resets.
- There's default risk if the issuer can't repay the principal.
- If market rates fall, FRN rates drop too.
- They typically pay less than fixed-rate counterparts.
Example of a Floating Rate Note (FRN)
Take the U.S. Treasury's FRNs, which started in 2014. You need at least $100 to buy in, with a two-year maturity. At maturity, you get the face value back. The variable rate benchmarks to the 13-week Treasury bill, with quarterly interest payments.
You can hold them until maturity or sell earlier. They're issued electronically, and the interest income is taxable at the federal level.
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