What Is a FRN (Floating Rate Note)?

A Floating Rate Note (FRN) is a type of debt instrument where the interest payments to the bondholder are not fixed but instead adjust periodically. Unlike traditional bonds, an FRN’s interest rate changes based on a predetermined formula. These notes represent a loan made by an investor to a borrower, which could be a corporation, financial institution, or government entity.

Understanding Floating Rate Notes

Floating Rate Notes are financial instruments whose interest rate is tied to a benchmark rate, meaning their interest payments fluctuate over time. This structure contrasts with fixed-rate bonds, which pay the same coupon rate from issuance until maturity. The interest rate on an FRN is typically reset at regular intervals, such as every three months or six months, ensuring the payment reflects prevailing market rates.

The interest paid on an FRN is determined by adding a specified percentage, known as a “spread,” to a chosen benchmark interest rate. For example, an FRN might pay interest at the Secured Overnight Financing Rate (SOFR) plus a spread of 0.50%. If the SOFR increases, the interest payment on the FRN will also increase, and conversely, it will decrease if the SOFR falls. This mechanism provides investors with an income stream that adapts to changes in the broader economic environment.

The variable nature of the interest income means that the amount an investor receives from an FRN can change significantly over its life. Investors receive regular interest payments, which are typically made quarterly or semi-annually, based on the newly adjusted rate. The principal amount of the note is then repaid to the investor at maturity, similar to other debt securities.

Key Features of Floating Rate Notes

Floating Rate Notes are defined by several specific components that dictate their payment structure and overall behavior.

Benchmark Rate

A primary feature is the benchmark rate, which serves as the foundation for calculating interest payments. Common benchmark rates include the Secured Overnight Financing Rate (SOFR) or the prime rate. These benchmark rates reflect the general cost of borrowing in the financial markets and are subject to continuous change.

Spread

Another defining characteristic is the “spread,” which is added to the benchmark rate to determine the FRN’s coupon rate. This spread reflects the credit risk of the issuer, meaning a higher spread typically indicates a perception of greater risk associated with the borrower. For instance, an issuer with a strong credit rating might offer an FRN at SOFR plus 0.20%, while an issuer with a lower rating might offer SOFR plus 0.75%. The spread is usually fixed for the life of the note, while the benchmark rate fluctuates.

Reset Frequency

The “reset frequency” specifies how often the FRN’s interest rate is adjusted. This could be monthly, quarterly, or semi-annually, with quarterly resets being a common arrangement. Each time the rate resets, the new interest payment is calculated based on the current benchmark rate plus the predetermined spread. This regular adjustment ensures that the FRN’s yield remains responsive to prevailing market conditions.

Maturity Date

Like other bonds, FRNs also have a defined maturity date, indicating when the principal amount will be repaid to the investor. Maturities can range from short-term, such as one year, to long-term, spanning ten years or more.

The Market Role of Floating Rate Notes

Floating Rate Notes serve distinct purposes for both issuers and investors.

For Issuers

From an issuer’s perspective, FRNs can be a strategic tool for managing interest rate exposure. By issuing debt with a floating rate, a company or government can align its borrowing costs with its revenue streams, especially if those revenues are also sensitive to changes in interest rates. This can help to mitigate the risk of a mismatch between assets and liabilities in a rising rate environment.

For Investors

Investors consider FRNs for their ability to provide an income stream that adjusts with market interest rates. During periods of rising interest rates, the interest payments on FRNs will increase, potentially offering a degree of stability in purchasing power. This characteristic can make them attractive to investors who are concerned about the eroding effects of inflation on fixed-income returns. Institutions, such as banks or money market funds, often utilize FRNs to manage liquidity and interest rate risk within their portfolios.

The structure of FRNs allows them to function effectively in environments where interest rates are volatile or trending upwards. For investors seeking to earn variable income, FRNs offer a mechanism to participate in interest rate movements. Similarly, for borrowers looking to finance operations, FRNs provide a flexible financing option.