What is a variable rate note (FRN)?
A variable rate note (FRN) is a debt instrument with a variable interest rate. The interest rate of an FRN is linked to a benchmark rate. Benchmarks include the US Treasury bill rate, the Federal Reserve funds rate, known as the Federal Funds rate, the London Interbank Offered Rate (LIBOR), or the prime rate.
Floating rate notes or floating securities may be issued by financial institutions, governments and corporations for maturities of two to five years.
Key points to remember
- A floating rate note is a bond with a variable interest rate, as compared to a fixed rate note whose interest rate does not fluctuate.
- The interest rate is linked to a short-term benchmark rate, such as LIBOR or the federal funds rate, plus a quoted spread or stable rate.
- Many floating rate notes have quarterly coupons, which means they pay interest four times a year, but some pay monthly, semi-annually, or annually.
- FRNs appeal to investors because they can benefit from higher interest rates as the rate on the float periodically adjusts to current market rates.
Understanding Variable Rate Notes (FRN)
Floating Rate Notes (FRNs) constitute a significant portion of the US investment grade bond market. Compared to fixed rate debt securities, floats allow investors to benefit from higher interest rates as the rate on the float periodically adjusts to current market rates. Floats are typically compared to short-term rates like the Federal Funds Rate, which is the rate set by the Federal Reserve for short-term borrowing between banks.
Typically, the rate or return paid to an investor on a US Treasury bond or product increases with term to maturity. The rising yield curve offsets investors who hold longer-term securities. In other words, the yield on a 10-year bond should yield, under normal market conditions, a higher yield than that on a two-month bond.
As a result, floating rate bonds typically provide investors with a lower return than their fixed rate counterparts, as floats are compared to short-term rates. The investor forfeits a portion of the return for the security of having an investment that increases as his benchmark rate increases. However, if the short-term benchmark rate drops, so does the FRN rate.
There can be no assurance that the FRN rate will rise as fast as interest rates in a rising rate environment. It all depends on the performance of the benchmark rate. As a result, a holder of FRN bonds may still have interest rate risk, which means that the bond’s rate is underperforming the overall market.
Since the bond rate can adjust to market conditions, the price of an FRN tends to have less volatility or price fluctuations. Traditional fixed rate bonds usually slide when rates rise, as existing bondholders lose out by holding a product that offers a lower rate.
FRNs avoid some of the market price volatility because there are fewer opportunity costs for bondholders in a rising rate market. As with any bond, FRNs are exposed to the risk of default, which occurs when the company or government cannot repay the principal or the initial amount paid by the investor.
Since floats have variable rates, they tend to have unpredictable coupon payments. A coupon payment is the payment of interest on a bond. Sometimes a float can have a ceiling and a floor, which allows an investor to know the maximum and minimum interest rates paid by the note.
The interest rate on an FRN can change as often or as frequently as the issuer wishes, from once a day to once a year. The reset period, which is described in the bond’s prospectus, tells the investor how often the rate adjusts. The issuer can pay interest monthly, quarterly, semi-annually or annually.
Redeemable variable rate security vs. Non-redeemable variable rate security
FRNs can be issued with or without a callable option, which means that the issuer has the right to return the capital to the investor and to stop paying the interest. The call function is known in advance and allows the issuer to redeem the bond before maturity.
Floating rate notes allow investors to benefit from rising rates as the FRN rate adjusts to the market
FRNs are less impacted by price volatility
FRNs are available in US Treasuries and corporate bonds
FRNs may still have an interest rate risk if market rates rise more than rate revisions
FRNs may have a risk of default if the issuing company or the company cannot repay the principal
If market interest rates fall, FRN rates may fall too
FRNs typically pay a lower rate than their fixed rate counterparts
Example of a Variable Rate Note (FRN)
- The minimum purchase amount of $ 100
- Two-year term or term
- At maturity, the investor receives the face value of the note
- Pay a variable rate indexed to the 13-week Treasury bill
- Pay interest or coupons quarterly
- FRNs can be held to maturity or sold before maturity
- Issued electronically
- Interest income is subject to federal income tax