Floating Rate Note

A Floating Rate Note (FRN) is a type of debt security that has a variable interest rate, which is usually adjusted periodically based on a reference interest rate. These notes are often issued by governments and corporations to raise capital, and their yields tend to fluctuate with market interest rates.

Key Features of Floating Rate Notes

• Interest Rate Adjustment: The interest rate on FRNs is linked to a benchmark interest rate, such as LIBOR (London Interbank Offered Rate) or SOFR (Secured Overnight Financing Rate), which is adjusted at regular intervals.
• Reset Period: The reset period is the frequency with which the interest rate is adjusted. Common reset periods include quarterly, semi-annually, or annually.
• Risk and Return: Because the interest payments fluctuate, FRNs typically carry less interest rate risk than fixed-rate bonds, making them attractive in rising interest rate environments.

How Floating Rate Notes Work

FRNs pay interest based on a formula that typically involves adding a fixed spread to a reference rate. For example, the interest payment can be calculated using the following formula:

• Coupon Payment = Face Value × (Reference Rate + Spread)

Example of a Floating Rate Note

Assume a company issues a 5-year FRN with a face value of $1,000, a spread of 2%, and it resets its rate quarterly based on the 3-month LIBOR rate. For the first reset, if the LIBOR rate is 1%, the coupon payment is calculated as follows:

• Reference Rate = 1% (3-month LIBOR)
• Spread = 2%
• Coupon Payment = $1,000 × (1% + 2%)
• Coupon Payment = $1,000 × 3%
• Coupon Payment = $30

This means the holder of the FRN would receive $30 in interest for that quarter. If the LIBOR rate changes in subsequent resets, the interest payment will also change correspondingly.

Benefits and Risks of Floating Rate Notes

• Benefits:
  • Less sensitive to interest rate changes compared to fixed-rate bonds.
  • Potential for higher returns in rising interest rate environments.
• Risks:
  • Payments may decrease if reference rates fall.
  • There may be more volatility in cash flows than with fixed-rate securities.

Floating Rate Notes are suitable for investors looking for a hedge against rising interest rates while being willing to accept some variability in income.