Floating Rate Note (FRN)

What Is a Floating Rate Note?

A floating rate note is a type of bond that pays interest at a rate that changes over time. Instead of paying a fixed coupon for the life of the security, an FRN links its interest payment to a benchmark rate, such as a short-term reference rate that banks use to price loans. The issuer, which may be a government, a corporation, or a financial institution, borrows money from investors and repays the principal at maturity, just as with other debt securities.

How It Works

Each FRN specifies a reference rate and a spread. The spread is a fixed number of percentage points added to the reference rate, and it stays the same for the life of the note. The coupon is typically reset at regular intervals, such as every three or six months. At each reset date, the current reference rate is observed and the new coupon is set for the next period.

The formula can be expressed as:

Coupon rate = Reference rate + Spread

Many FRNs also include a floor, which sets a minimum coupon, and sometimes a cap, which sets a maximum. These features affect how much the investor can gain or lose when rates move sharply.

Why It Matters to Investors

The main appeal of an FRN is lower sensitivity to interest rate risk. When market rates rise, the coupon rises at the next reset, so the price of the note tends to stay close to its face value. A conventional fixed-rate bond, by contrast, usually falls in price when rates rise. For this reason, FRNs are often viewed as a way to reduce price volatility in a bond holding.

The trade-off is that the income an investor receives can fall when rates decline. Investors also face credit risk, because the note's value depends on the issuer's ability to make payments. Liquidity can be lower than for large government issues, and the spread may not fully compensate for changes in the issuer's creditworthiness.

Common Features

FRNs are issued by governments, banks, and corporations. Some are issued with very long maturities, while others are short-dated. Because the coupon adjusts, the price of an FRN usually trades near par between reset dates, although it can drift from par if the issuer's credit quality changes or if market demand shifts. Investors often compare an FRN with a money market instrument or a fixed-rate bond when considering how each might fit into a portfolio.