Floating-rate note

What is a Floating-Rate Note?

A floating-rate note (FRN) is a type of debt instrument that pays interest based on a variable interest rate. Unlike fixed rate notes, which have a constant interest rate, the interest rate on FRNs typically adjusts periodically. The adjustment period, known as the reset period, can vary but is often quarterly. The coupon rate on an FRN is tied to a benchmark rate, such as the London Interbank Offered Rate (LIBOR) or the federal funds rate, plus a fixed spread.

In a rising interest rate environment, floating-rate securities are particularly appealing to investors because their interest payments increase as interest rates rise. This feature helps mitigate interest rate risk, which is the risk that changes in market interest rates will negatively affect the value of fixed-income securities. Consequently, FRNs can offer protection against rising rates, making them a valuable component of a diversified financial plan.

LIBOR), Secured Overnight Financing Rate (SOFR), or the prime rate. The coupon rate is determined by adding a fixed spread to the current reference rate. For example, if the benchmark rate is LIBOR and the fixed spread is 50 basis points (0.50%), the coupon payment will be LIBOR + 0.50%.

FRNs usually have a reset period, often quarterly, during which the interest rate is adjusted to reflect changes in the benchmark rate. This periodic adjustment helps keep the interest payments in line with current market rates, providing a hedge against rising interest rates. When interest rates rise, the interest payments on FRNs also rise, making them attractive in a rising rate environment.

Floating-Rate Notes Importance

1. Investor Benefits. FRNs allow investors to earn higher yields when interest rates rise. For example, if an investor buys a five-year Treasury bill and the federal funds rate rises by four percentage points, the interest payments on the Treasury bill remain unchanged. However, with an FRN, the investor would receive higher interest payments in such a rising rate environment. This ability to adjust to higher interest rates provides a hedge against interest rate risk and makes FRNs particularly attractive during periods of rising rates.

2. Issuer Benefits. From the issuer's perspective, FRNs offer several advantages. Firstly, FRNs typically have lower initial yields compared to fixed rate bonds of similar maturities. This can result in lower borrowing costs for the issuer at the outset. Additionally, in a high-interest environment, issuing FRNs allows issuers the possibility of lower borrowing costs if benchmark interest rates fall in the future. This flexibility can be a strategic financial planning tool for issuers looking to manage their debt costs effectively.

3. Lower Initial Yields. FRNs typically offer lower initial yields than fixed-rate notes. This is beneficial for issuers as it reduces their initial cost of borrowing. For investors, while the initial yield might be lower, the potential for increasing interest payments in a rising-rate environment can make FRNs a more attractive investment over time.

4. Adaptability to Market Conditions. FRNs are tied to specific benchmark rates, such as the fed funds rate, and their coupon payments adjust accordingly. This adaptability ensures that the interest payments are aligned with current market rates, providing a more responsive and potentially more lucrative investment compared to fixed-rate notes, especially when market rates rise.

5. Investment Grade and Liquidity. Many FRNs are considered investment grade, providing a relatively safe investment with the benefit of variable interest payments. They are also actively traded in the secondary market, offering liquidity to investors. This means that investors can sell their FRNs before maturity if needed, which adds to the attractiveness of these instruments.

6. Hedging Against Interest Rate Risk. FRNs provide a natural hedge against interest rate risk. As market rates rise, the coupon payments on FRNs increase, ensuring that investors' income keeps pace with the rising interest rates. This is in stark contrast to fixed-rate bonds, where the interest payments remain unchanged regardless of market fluctuations.

Benefits and Risks

Benefits

1. Benefit from Rising Interest Rates. Investors often hesitate to lock in a current fixed rate for the long term, anticipating that interest rates will rise in the future. Floating-rate notes provide a solution by offering a spread above current short-term rates, benefiting from future rate increases.

2. Limited Price Sensitivity to Interest Rates. Fixed-rate bonds tend to decrease in value when interest rates rise and increase in value when rates fall, as their fixed coupon rate becomes less attractive compared to new issuances. However, the coupon rate on FRNs adjusts with market rates, leading to less price fluctuation compared to fixed rate bonds of similar maturity.

3. Secondary Market. While FRNs are most suitable for holding to maturity, they can be traded in the secondary market, providing liquidity. Investors may need to sell their floating-rate investments prior to maturity, and the secondary market allows them to do so at prevailing market levels, which could be higher or lower than the purchase price.

Risks

1. Reference Rate Risk. The income received from FRNs is highly dependent on the reference rate over the life of the investment. While FRNs are relatively insensitive to changes in interest rates under normal circumstances, total return can be less than anticipated if future interest rate or reference rate expectations are not met.

2. Credit Risk. As with any fixed-income investment, there is a risk that the issuer might not meet its payment obligations. Changes in the issuer's creditworthiness can decrease or increase the market value of the FRN, potentially leading to a partial or total loss of the investment.

3. Call Risk. Some FRNs are callable, meaning the issuer can repay the note before its maturity. If a callable floating-rate note is called by the issuer prior to maturity, investors might face difficulty reinvesting the funds in another floater with comparable terms. Investors should be prepared to hold the FRN until maturity if it is not called.

Who Issues Floating-Rate Notes?

Sovereigns, Government-Sponsored Enterprises (GSEs) and corporations issue floating-rate notes (FRNs) as part of their overall funding strategy. These issuers utilize FRNs to meet various financial needs while taking advantage of the benefits that come with variable rates.

Sovereign countries issue Floating-Rate Notes as a part of their debt financing strategies. Сountries such as Japan, Italy and the US issue floating rate bonds. Japan issues bonds with benchmark Japan 10-year YTM, Italy issues more frequently 6-month EURIBOR and USA with benchmark 13W Treasury Bill Auction High Rate (USA).

GSEs such as Fannie Mae, Freddie Mac, and the Federal Home Loan Banks issue floating-rate notes to manage their funding requirements. These entities often need to raise large amounts of capital to support their operations and lending activities. By issuing FRNs, GSEs can offer investors securities with interest payments that adjust to market rates, making them attractive in different interest rate environments.

Corporations also issue floating-rate notes as part of their capital-raising strategies. By issuing FRNs, corporations can benefit from potentially lower borrowing costs if benchmark interest rates fall in the future. This flexibility is particularly valuable in high-interest environments. Corporations may choose to issue FRNs instead of fixed-rate notes to avoid locking in high interest rates for long periods.

Structure

1. Benchmark and Spread. The coupon rate of a floater is determined by adding a quoted spread to the reference rate. For example, a floater might be structured with a monthly reset based on the % change in CPI + 150 basis points (bp). Another example could be a quarterly reset based on the 3-month LIBOR + 100 bp.

2. Reset Frequency. The reset frequency indicates how often the interest rate is adjusted. It can vary from daily to annually. Typically, the coupon resets each time an interest payment is made and remains constant until the next payment date. For instance, a monthly reset with quarterly interest payments will have its coupon reflect the average of the monthly resets over the quarter.

3. Callable vs. Non-Callable. Floaters can be issued as either callable or non-callable. Callable floaters give the issuer the option to repay the principal and stop making interest payments before the maturity date. Non-callable floaters remain outstanding until maturity.

4. Maturity. Floaters are issued with various maturities, often between two to five years, though some can be as long as 10 years or even perpetual, with no stated final maturity date.

Types of Floating-Rate notes

1. Vanilla FRNs: Standard bonds with interest payments tied to a benchmark rate (LIBOR, SOFR, e.g.) plus a fixed spread. Example: International bonds: American Honda Finance, FRN 9jan2026, USD (A) (US02665WEX56).

2. Perpetual FRNs: No maturity date; investors receive periodic interest indefinitely unless redeemed. Example: International bonds: Nordic Investment Bank (NIB), FRN perp., CHF (CH0004724545).

3. Capped/Collared FRNs: Include a cap (maximum) and/or floor (minimum) on interest rates to limit variability. Example: JP Morgan Bonds, FRN 15aug2034, USD (E) (US48130CQX64).

4. Structured FRNs: Linked to non-standard benchmarks like inflation, equity indices, or commodity prices. Example: International bonds: GS Financial, FRN 13mar2053, CLP (A, Structured) (XS1788987441).

5. Convertible FRNs: Can be converted into equity or another form of security. Example: Doverie United Holding Bonds, FRN 2apr2029, BGN (Conv.) (BG2100033237).

Example

The U.S. Treasury Department issues floating-rate notes (FRNs) that are marketable Treasury securities with a two-year maturity term. These FRNs pay interest four times per year with quarterly coupons and have interest rates that can change throughout the term.

sovereign countries issue Floating-Rate Notes (FRNs) as a part of their debt financing strategies.an

The interest rate of a Treasury FRN is tied to the yield of the 13-week Treasury bill. The coupon determined by this Treasury rate is applied to a spread, producing the current interest rate of the FRN. For example, if the 13-week Treasury bill yield is 2.00% and the spread is 0.25%, the floating-rate would be 2.25%.

These floating-rate notes are available for purchase directly from the Treasury in $100 increments and are issued in January, April, July, and October. Institutional investors and individual investors alike value these instruments for their ability to adjust to changing market rates, offering a completely hedged investment against rising interest rates while maintaining stable face value.

Example: USA Bonds, Notes FRN 31jul2026, USD (BF-2026) (US91282CLA70)