Key Takeaways
- Debt with interest rates that reset periodically.
- Coupons equal reference rate plus fixed spread.
- Protects investors from rising interest rates.
- Matures typically within 1 to 5 years.
What is Floating Rate Note (FRN)?
A Floating Rate Note (FRN) is a debt instrument with a variable interest rate that resets periodically based on a benchmark reference rate plus a fixed spread. This structure helps protect investors from rising interest rates, unlike fixed-rate bonds that lock in a coupon.
FRNs typically have maturities of 1 to 5 years and pay interest quarterly or at other regular intervals. The coupon calculation depends on market rates such as SOFR or the federal funds rate, making them responsive to current economic conditions.
Key Characteristics
FRNs have distinct features that differentiate them from other bonds. Key points include:
- Variable coupon: Interest payments adjust periodically based on a reference rate plus a fixed spread, maintaining income aligned with market rates.
- Reset frequency: Coupons commonly reset quarterly, with interest accruing daily using a specific day count convention.
- Maturity: Usually short to intermediate term, often between 1 and 5 years, reducing interest rate risk.
- Reference rates: Benchmarks include SOFR, federal funds rate, or 13-week Treasury bill discount rate, which U.S. Treasury FRNs use for weekly resets.
- Callable options: Some FRNs are callable bonds, allowing issuers to redeem early, affecting yield and reinvestment risk.
How It Works
FRNs calculate each coupon payment as the sum of a fluctuating reference rate plus a fixed spread determined at issuance. For example, a corporate FRN might pay 3-month SOFR plus 0.20%, resetting every quarter to reflect current market conditions.
This variable structure means the bond’s price tends to stay close to its face value, since coupon adjustments offset interest rate changes. The reset mechanism reduces duration risk compared to fixed-rate bonds and appeals to investors seeking income linked to prevailing rates.
Examples and Use Cases
FRNs are widely used by governments and corporations to manage interest rate exposure and provide investors with adjustable income streams. Examples include:
- Airlines: Companies like Delta and American Airlines may issue FRNs to fund operations while limiting interest rate risk in volatile markets.
- Government securities: U.S. Treasury FRNs have 2-year maturities and reset weekly using Treasury bill discount rates, offering a low-risk floating income option.
- Bond ETFs: Funds such as BND may include FRNs to diversify income sources and hedge against rising rates.
Important Considerations
When investing in FRNs, be mindful of credit risk from the issuer and the potential for lower returns if reference rates decline. Callable FRNs add reinvestment risk since issuers may redeem bonds early, especially if rates fall.
Understanding the coupon reset schedule and reference rate used is vital for evaluating expected income. You may also want to compare FRNs with fixed-rate bonds or explore bond ETFs to determine the best fit for your portfolio.
Final Words
Floating rate notes offer protection against rising interest rates by adjusting coupons based on market benchmarks, making them a flexible income option. To evaluate if FRNs fit your portfolio, compare current spreads and reference rates across issuers before investing.
Frequently Asked Questions
A Floating Rate Note (FRN) is a debt security with an interest rate that adjusts periodically based on a benchmark reference rate plus a fixed spread. This structure helps protect investors from rising interest rates by providing income that tracks market rates.
Interest payments on FRNs are calculated using a reference rate, such as SOFR or federal funds rate, plus a fixed spread that remains constant throughout the note's life. The coupon resets at the start of each period, often quarterly, to reflect current market rates.
Common types of FRNs include callable FRNs which can be redeemed early by the issuer, non-callable FRNs with fixed maturity, leveraged floaters that amplify exposure to rate changes, deleveraged floaters that reduce exposure, and floored or collared FRNs that set minimum and maximum coupon limits.
Investors may prefer FRNs because their coupons adjust with market interest rates, offering protection against rising rates. Unlike fixed-rate bonds, FRNs tend to maintain stable prices near par value, reducing interest rate risk.
FRNs usually have maturities ranging from 1 to 5 years, with U.S. Treasury FRNs specifically maturing in 2 years. Interest payments are commonly made quarterly, though some FRNs pay monthly, semiannually, or annually.
U.S. Treasury FRNs mature in 2 years, reset rates weekly based on the 13-week Treasury bill discount rate, and have a minimum purchase of $100 increments. Corporate FRNs, on the other hand, typically have longer maturities and their reference rates may include SOFR or other benchmarks.
While FRNs reduce interest rate risk, they still carry credit risk depending on the issuer. Callable FRNs introduce reinvestment risk if the issuer redeems early, and variations like leveraged floaters can increase exposure to rate volatility.
Non-callable FRNs offer more predictable cash flows because they cannot be redeemed early, making them suitable for investors seeking steady income. However, since coupons adjust with reference rates, exact payment amounts can vary each period.
