Floating-Rate Note (FRN): Variable Interest Rate Bonds Explained

A Floating-Rate Note (FRN) is a type of bond with a variable interest rate that adjusts periodically. Learn about how FRNs work, their benefits, and their place in investment portfolios.

A Floating-Rate Note (FRN) is a bond with a variable interest rate that typically adjusts periodically, often in relation to a benchmark interest rate like LIBOR (London Interbank Offered Rate) or SOFR (Secured Overnight Financing Rate). This adjustment allows the interest payments to move up or down with changes in the benchmark rate, providing a dynamic income stream.

Types of Floating-Rate Notes

Different FRNs exist to cater to various investment needs and risk preferences. Common types include:

• Corporate FRNs: Issued by corporations, these notes often provide higher yields due to increased credit risk compared to government-issued bonds.
• Government FRNs: Generally considered low-risk, these are issued by governmental entities.
• Callable FRNs: These can be redeemed by the issuer before maturity, typically at a predetermined price.

KaTeX Formulas

The interest rate (I) on a typical FRN can be expressed as:

$$ I = R + B $$

where \( R \) is a reference rate (such as LIBOR) and \( B \) is the spread or margin.

Special Considerations

FRNs offer protection against interest rate risk as their rates adjust with market changes. However, they might expose investors to other risks, such as:

• Credit Risk: The issuer’s ability to meet its financial obligations.
• Liquidity Risk: The ease of buying or selling the note in the market.

Examples and Case Studies

Consider an FRN issued by a corporation with a 3-month LIBOR as the benchmark rate and a margin of 2%. If the 3-month LIBOR is 1.5%, the interest rate for that period is:

$$ I = 1.5\% + 2\% = 3.5\% $$

Historical Context

Floating-Rate Notes emerged in the financial markets around the late 1970s in response to the volatile interest rates of that era. They have since become a popular financial instrument for managing interest rate risk.

Applicability

FRNs are favored by investors looking for:

• Protection against rising interest rates.
• A regular income stream that keeps pace with market interest rates.
• Diversification in fixed-income portfolios.

Comparisons

FRNs vs. Fixed-Rate Bonds

Unlike fixed-rate bonds, which pay a stable interest rate, FRNs adjust their payments, offering potential upside with rising rates.

FRNs vs. Inflation-Linked Bonds

Both adjust with economic conditions, but while FRNs respond to interest rate changes, inflation-linked bonds adjust based on inflation rates.

Related Terms

• Fixed-Rate Bonds: Bonds that pay a constant interest rate.
• Benchmark Rate: The reference interest rate upon which FRNs are based.
• LIBOR: A common benchmark rate for FRNs.

FAQs

How often do interest rates on FRNs adjust?

Typically, the interest rates on FRNs adjust quarterly, semi-annually, or annually.

Can FRNs lose value?

Yes, while they provide interest rate protection, they can lose value if the issuer’s creditworthiness declines or there is a lack of market liquidity.

Are FRNs suitable for all investors?

FRNs are generally suitable for investors who seek income that adjusts with market conditions and are comfortable with the associated risks.

References

1. Investopedia: Floating Rate Notes
2. Federal Reserve: Insights into Floating-Rate Notes

Summary

Floating-Rate Notes are dynamic investment instruments that offer a variable interest rate tied to benchmark rates. They provide protection against interest rate fluctuations and a potential hedge in rising rate environments. Investors should weigh their benefits and risks to align them with their investment strategies.