Floating-Rate Note (FRN)

A Floating-Rate Note (FRN) is a type of debt instrument with a variable interest rate that adjusts periodically based on a benchmark interest rate, such as the LIBOR or the federal funds rate.
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Floating-Rate Note (FRN) Defined

A Floating-Rate Note (FRN) is a bond with an interest rate that fluctuates over time. Unlike fixed-rate bonds, which have a constant interest rate throughout their life, the interest rate on an FRN is periodically reset based on a reference rate or benchmark index. Common benchmarks include the London Interbank Offered Rate (LIBOR), the federal funds rate, or the prime rate. This adjustable rate mechanism helps the FRN maintain a value closer to its issuing price, reducing interest rate risk for investors.

Key Features

  • Interest Rate Adjustment: The interest rate on an FRN is typically adjusted every three to six months.
  • Reference Rate: Adjustments are based on a specific benchmark such as LIBOR, T-bill rate, or the federal funds rate.
  • Coupons: Interest payments (coupons) are made at each adjustment interval and reflect the new interest rate.
  • Lower Interest Rate Risk: FRNs are less susceptible to interest rate risk compared to fixed-rate bonds, as their rates are aligned with current market conditions.

Examples of Floating-Rate Notes

  1. U.S. Treasury Floating Rate Notes: These are FRNs issued by the U.S. Department of the Treasury. They adjust their interest rates based on the 13-week Treasury bill yield.
  2. Corporate Floating-Rate Bonds: Companies issue FRNs with rates tied to benchmarks like LIBOR or another index.
  3. Municipal Floating-Rate Bonds: Local governments and municipalities issue FRNs for funding projects, with rates often pegged to a specified reference rate.

Frequently Asked Questions (FAQs)

Q1: What is the advantage of investing in an FRN?

  • A: FRNs provide a hedge against rising interest rates as their yields adjust with market rates, offering more stable income compared to fixed-rate bonds.

Q2: How often do the interest rates of FRNs adjust?

  • A: The interest rates on FRNs generally adjust every three to six months, depending on the terms set at issuance.

Q3: Can the interest rate on an FRN ever be lower than its initial rate?

  • A: Yes, if the benchmark rate decreases, the interest rate on the FRN will also decrease.

Q4: Are floating-rate notes risk-free?

  • A: No. While they reduce interest rate risk, they still carry default risk, credit risk, and market risk.

Q5: Are FRNs suitable for all investors?

  • A: Generally, FRNs may be more suitable for conservative investors seeking income that adjusts with market conditions, though they might not be appropriate for those needing fixed and predictable income streams.
  • Interest Rate Risk: The risk that changes in interest rates will negatively affect the value of financial instruments.
  • Benchmark Rate: A standard interest rate or index that serves as a basis for setting the interest rate on a floating-rate financial product.
  • LIBOR (London Interbank Offered Rate): A widely-used benchmark interest rate at which banks lend to one another.
  • Coupon: The interest payment made to the bondholder on a set periodic schedule.

Online References

  1. Investopedia - Floating-Rate Note (FRN)
  2. U.S. Treasury – Floating Rate Notes
  3. Federal Reserve - FRNs

Suggested Books for Further Studies

  1. “Fixed Income Securities: Tools for Today’s Markets” by Bruce Tuckman and Angel Serrat
  2. “The Handbook of Fixed Income Securities” by Frank J. Fabozzi
  3. “Bond Markets, Analysis, and Strategies” by Frank J. Fabozzi

Accounting Basics: Floating-Rate Note (FRN) Fundamentals Quiz

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Floating-Rate Note (FRN)