What is a Floating Rate Note (FRN)?
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 ultimately variable and is typically composed of a variable benchmark rate + a fixed spread.
The coupon rate is usually quoted as a benchmark rate plus a fixed quoted spread. The rate is adjusted monthly or quarterly. The maturity period of FRN’s vary but are typically in the range of two to five years.
Floating rate notes 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, floating rate notes offer an advantage over plain vanilla bonds. Plain Vanilla Bond Prices are inversely related to their expected return yield, as was discussed on 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 the increase in interest rate. The rationale behind the fact is that adjustments of the floating rate note to the current interest rate levels makes the note’s duration close to zero. The elegant math behind the concept is explained in the Math for Corporate Finance Course.
At the same time, a holder of a floating rate note benefits from the interest rate increase because the note’s coupon rate grows accordingly.
Learn more with CFI’s Fixed Income Fundamentals Course
Risks of Floating Rate Notes
Floating rate notes, especially those issued by the governments, are 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 a credit risk. Since the governments and private entities could issue floating rate notes, 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, a decline in the benchmark interest rate would decrease the value of the bond. Also, they are not completely hedged from interest rate risk as there are multiple benchmark interest rates, and a FRN is typically linked to one.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following resources: