Floating-Rate Note (FRN)

Key takeaways
* A floating-rate note (FRN) is a debt security with a variable interest rate tied to a short-term benchmark (e.g., Treasury bill rate, Fed funds rate, LIBOR, prime) plus a fixed spread.
* FRN coupon payments reset periodically (daily to yearly) according to a prospectus-specified reset period and are often paid quarterly.
* FRNs tend to have lower price volatility than fixed-rate bonds and can benefit investors when short-term rates rise, but they remain exposed to default risk and potential underperformance if resets lag market rates.

What is an FRN?

A floating-rate note (FRN) is a bond whose interest rate fluctuates over time. The coupon rate equals a reference benchmark rate plus a quoted spread (for example, 3-month Treasury bill + 0.25%). The benchmark and spread determine the interest investors receive until the next reset.

How FRNs work

• Benchmark linkage: The coupon resets based on changes in a short-term benchmark rate. Common benchmarks include Treasury bill yields, the federal funds rate, LIBOR (historically), and the prime rate.
• Reset period and coupon frequency: The prospectus specifies how often the coupon is reset (daily, weekly, monthly, quarterly, semiannually, or annually) and how often interest is paid (commonly quarterly).
• Caps and floors: Some FRNs include maximum (cap) or minimum (floor) coupon limits, providing known bounds on payments.
• Pricing and volatility: Because the coupon adjusts with market rates, FRNs typically exhibit less price volatility than fixed-rate bonds when interest rates move.

Yield and tradeoffs

• FRNs usually offer lower starting yields than comparable fixed-rate bonds because they transfer part of long-term yield premium in exchange for rate adjustment protection.
• In a rising-rate environment, FRN holders benefit as coupons increase. If short-term rates fall, coupons decline.
• Reset timing and the relationship to broader market rates may cause FRNs to underperform if benchmark rates lag or move faster than the reset mechanism.

Risks

• Interest-rate risk: Although reduced relative to fixed-rate bonds, FRNs can still underperform if resets do not keep pace with market rate changes.
• Default (credit) risk: Issuers may fail to pay interest or principal. Credit risk applies to corporate and some government issuers (less so for sovereign or high-quality government-backed issues).
• Reinvestment risk: Variable coupons change expected cash flows, affecting reinvestment planning.
• Liquidity and secondary-market risk: Some FRNs may be less liquid, affecting sale price before maturity.

Callable vs. non-callable FRNs

• Callable FRNs allow the issuer to repay principal early and stop future coupon payments. This feature tends to be exercised when interest rates fall, disadvantaging investors.
• Non-callable FRNs cannot be redeemed early and provide more certainty about maximum holding period.

Example: U.S. Treasury FRNs

The U.S. Treasury issues FRNs with these typical features:
* Minimum purchase: $100 (electronic issuance)
* Maturity: two years
* Benchmark: 13-week Treasury bill rate
* Coupon payments: quarterly, reset at each coupon period
* At maturity: investor receives face value
* Interest income: subject to federal income tax

Conclusion

Floating-rate notes are useful for investors seeking reduced price sensitivity to rising short-term rates and variable-income exposure. They are appropriate when the goal is to mitigate interest-rate risk compared with fixed-rate bonds, but investors should weigh credit quality, reset mechanics, potential caps/floors, and callable features before investing.