Floating Rate Note: Definition, Benefits, and Risks
What Is a Floating Rate Note?
A Floating Rate Note (FRN) is a debt instrument whose coupon payments adjust periodically to a reference rate such as SOFR, LIBOR, or a Treasury bill yield. Because the interest resets, FRNs help investors hedge against rising rates while still earning predictable, schedule-based income.
Understanding Floating Rate Notes
Issued by governments, supranational agencies, and corporations, FRNs usually mature in two to five years. At each reset date—often every three or six months—the issuer pays a coupon equal to the benchmark rate plus or minus a fixed spread reflecting credit risk.
Example: a three-year FRN might pay SOFR + 0.50%. If SOFR climbs from 2% to 3%, the coupon automatically rises from 2.50% to 3.50%, preserving income that a fixed-rate bond would lose.
How Interest Payments Work
The coupon formula appears in the prospectus. On each reset date, the calculation agent records the benchmark, adds the spread, and announces the new rate. The issuer then pays investors the updated interest at the next coupon date, usually monthly or quarterly.
Benefits for Investors
FRNs deliver several strategic advantages:
- Protection from rising short-term rates, helping maintain real income without frequent trading.
- Lower price volatility because coupon resets keep prices near par.
- Portfolio diversification; FRNs often move differently from fixed-rate bonds and stocks.
Potential Risks
Despite these strengths, FRNs carry notable risks:
- If rates fall, coupons decline, reducing income.
- Credit risk remains; the floating feature does not guarantee repayment.
- Market liquidity can be thin, especially for corporate issues, widening bid-ask spreads.
- Complexity: varied benchmarks, reset frequencies, and caps or floors can complicate valuation.
Is a Floating Rate Note Right for You?
FRNs fit investors who expect rates to rise, want short duration, and can accept credit risk. Others may choose bills or money-market funds.