A debt instrument whose coupon rate is tied to a benchmark interest rate
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A floating rate note (FRN) is a debt instrument whose coupon rate is tied to a benchmark rate such as LIBOR or the US Treasury Bill rate. Thus, the coupon rate on a floating rate note is variable. It is typically composed of a variable benchmark rate + a fixed spread.
The rate is adjusted monthly or quarterly in relation to the benchmark. The maturity period of FRN’s vary but are typically in the range of two to five years.
FRN’s are issued by governments, as well as private companies and financial institutions. The notes are typically traded over-the-counter.
Floating Rate Note vs. Plain Vanilla Bond
An investor may purchase a floating rate note when he or she expects the benchmark interest rate to increase in the near future. In case of a rate increase, an FRN offers an advantage over plain vanilla bonds. Plain Vanilla Bond Prices are inversely related to their expected return yield, as is discussed in the Fixed Income Fundamentals Course.
The value of plain vanilla bonds declines when the interest rate goes up, and the bond’s longer duration leads to greater losses in its value. However, the price of the floating rate note does not fall with an increase in interest rates. The adjustments of the FRN’s rate help it to maintain its value. The elegant math behind the concept is explained in the Math for Corporate Finance Course.
FRNs, especially those issued by governments, are generally considered safe investments. However, a potential investor in such debt securities should be aware of the following risks:
#1 Credit risk
Floating rate notes may be exposed to credit risk/default risk. Since both governments and private entities can issue FRNs, an investor should carefully assess the creditworthiness of the issuer.
#2 Interest rate risk
FRN coupon payments are linked to a benchmark rate, so they benefit from the interest rate increases. However, they are not completely hedged from interest rate risk as there are multiple benchmark interest rates and a FRN is typically linked to only one.
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