Floating-Rate Note (FRN)

What Is a Floating-Rate Note (FRN)?

A floating-rate note (FRN) is a debt instrument with a variable interest rate. The interest rate for a FRN is tied to a benchmark rate. Benchmarks incorporate the U.S. Treasury note rate, the Federal Reserve funds rate — known as the Fed funds rate — the London Interbank Offered Rate (LIBOR), or the prime rate.

Floating rate notes or floaters can be issued by financial institutions, governments, and corporations in maturities of two-to-five years.

Understanding Floating Rate Notes (FRNs)

Floating-rate notes (FRNs) make up a critical part of the U.S. investment-grade bond market. Compared with fixed-rate debt instruments, floaters permit investors to benefit from a rise in interest rates since the rate on the floater changes periodically to current market rates. Floaters are typically benchmarked against short-term rates like the Fed funds rate, which is the rate the Federal Reserve Bank sets for short-term borrowing between banks.

Commonly, the rate or yield paid to an investor on a bond or U.S. Treasury product rises with the time span until maturity. The rising yield curve repays investors for holding longer-term securities. As such, the yield on a bond with a 10-year maturity ought to pay — under normal market conditions — a higher yield than a bond with a two-month maturity.

Therefore, floating-rate notes generally pay a lower yield to investors than their fixed-rate partners since floaters are benchmarked to short-term rates. The investor surrenders a portion of the yield for the security of having an investment that rises as its benchmark rate rises. Be that as it may, assuming that the rate of the short-term benchmark falls, so too does the rate on the FRN.

There's no guarantee that the FRN's rate will rise as fast as interest rates in a rising-rate environment. Everything relies upon the performance of the benchmark rate. Subsequently, a FRN bondholder can in any case have interest rate risk meaning the bond's rate fails to meet expectations the overall market.

Since the bond's rate can acclimate to market conditions, a FRN's price will in general have less volatility or price variances. Traditional fixed-rate bonds commonly slide when rates rise on the grounds that existing bondholders are losing out by holding a product returning a lower-rate.

FRNs stay away from a portion of the market price volatility since there's less opportunity cost for the bondholders in a rising rate market. Likewise with any bond, FRNs are helpless to default risk, which happens when the company or government can't pay back the principal or original amount that was paid by the investor.

Since floaters have variable rates, they will quite often have capricious coupon payments. A coupon payment is the interest payment for a bond. Sometimes a floater might have a cap and a floor, which permits an investor to realize the maximum and least interest rates paid by the note.

A FRN's interest rate can change as frequently or as habitually as the issuer picks, from once per day to one time per year. The reset period, which is illustrated in the bond's prospectus lets the investor know how frequently the rate changes. The issuer might pay interest month to month, quarterly, semiannually, or every year.

Callable Floating Rate Note versus Non-Callable Floating Rate Note

FRNs might be issued despite everything a callable option, and that means the issuer has the privilege to return the investor's principal amount and stop making interest payments. The callable feature is known upfront and permits the issuer to pay off the bond before maturity.

The U.S. Treasury Department started giving floating-rate notes in 2014. The notes have the accompanying attributes and requirements:

• The base purchase amount of $100
• Term or maturity of two years
• At maturity, the investor gets the face value of the note
• Pays a variable rate benchmarked to the 13-week Treasury bill
• Pays interest or coupon payments quarterly
• FRNs can be held until maturity or sold before maturity
• Issued electronically
• Interest income is subject to Federal income charge

Features

• The interest rate is tied to a short-term benchmark rate, for example, LIBOR or the Fed funds rate, plus a quoted spread, or rate that holds consistent.
• Many floating-rate notes have quarterly coupons, implying that they pay interest four times every year, except some pay month to month, semiannually, or yearly.
• A floating-rate note is a bond that has a variable interest rate, versus a fixed-rate note that has an interest rate that doesn't change.
• FRNs appeal to investors since they can benefit from higher interest rates since the rate on the floater changes periodically to current market rates.