Floating-rate notes (FRNs) are bonds that offer a unique feature: a variable interest rate. Unlike traditional fixed-rate bonds, where the interest rate remains constant throughout the bond’s life, FRNs adjust their interest rate periodically to reflect changes in a specific benchmark rate.
How do floating-rate notes (FRNs) work?
Floating-rate notes (FRNs) offer a unique feature: a variable interest rate. Unlike traditional fixed-rate bonds, where the interest rate remains constant throughout the bond’s life, FRNs adjust their interest rate periodically to reflect changes in a specific benchmark rate.
An FRN’s interest rate, or coupon rate, comprises a reference rate and a spread or margin. The reference rate is a benchmark interest rate, such as the London Interbank Offered Rate (LIBOR), the Euro Interbank Offered Rate (EURIBOR), or the Secured Overnight Financing Rate (SOFR). This rate is used to set the initial interest rate for the FRN.
The spread or margin is a fixed percentage point added to the reference rate. It represents the additional yield investors receive for taking on the credit risk associated with the bond issuer. A higher credit risk typically corresponds to a higher spread.
Floating-rate notes example
Suppose you have an FRN with a coupon rate of 6-month LIBOR + 150 basis points. If the 6-month LIBOR is currently 3%, the coupon rate on your FRN would be 4.5% (3% + 1.5%).
As the 6-month LIBOR fluctuates, so will the coupon rate on your FRN. If the 6-month LIBOR increases to 4.0%, the coupon rate on your FRN will increase to 5.5%. Conversely, if the 6-month LIBOR decreases to 2.5%, the coupon rate on your FRN would decrease to 4%.
As the reference rate fluctuates over time, the FRN’s coupon rate adjusts accordingly. For instance, if the reference rate rises, the coupon rate will also increase, and vice versa. This mechanism helps protect investors from the adverse effects of rising interest rates, as their bond’s yield will automatically adjust upward.
Floating-rate notes formula to calculate coupon payment
To calculate the coupon payment for a floating-rate note (FRN), we use a simple formula:
- Coupon payment = (Reference rate + Spread) x Principal amount x Time period
Let’s break down each component:
- Reference rate: This is a benchmark interest rate, such as LIBOR or SOFR, used to determine the initial interest rate.
- Spread: This is a fixed percentage point added to the reference rate, representing the additional yield investors receive for taking on the credit risk associated with the bond issuer.
- Principal amount: This is the face value of the bond.
- Time period: This is the fraction of a year for which the interest payment is calculated. For example, the time period would be 0.5 for a semi-annual payment.
Example: Suppose you have an FRN with a principal amount of $1,000, a reference rate of 3%, a spread of 1.5%, and semi-annual interest payments.
- Coupon payment = (3% + 1.5%) x $1,000 x 0.5 = $22.50
Therefore, you would receive a coupon payment of $22.50 every six months.
It’s important to note that the reference rate can fluctuate over time, impacting the coupon payment. As the reference rate changes, the coupon payment will adjust accordingly. This mechanism helps to protect investors from the adverse effects of rising interest rates.
It’s important to note that while FRNs can mitigate interest rate risk, they are not entirely immune to it. Other factors, such as changes in credit quality or market conditions, can also impact the value of FRNs.
Why invest in floating-rate notes (FRNs)?
Floating-rate notes (FRNs) offer a unique investment opportunity with several compelling benefits. These bonds can be valuable for investors seeking to manage interest rate risk, potentially capture higher returns, and enjoy a steady income stream.
Interest rate risk mitigation. FRNs can be valuable for investors concerned about rising interest rates. As interest rates increase, the bond’s coupon rate will adjust upward, helping to preserve the bond’s value. This can be particularly beneficial in periods of rising inflation when interest rates tend to rise.
Potential for higher returns. FRNs can offer higher yields than fixed-rate bonds in a rising interest rate environment. This is because the coupon rate on an FRN will adjust upward as interest rates rise, while the coupon rate on a fixed-rate bond remains fixed.
Income stability. While the interest rate on an FRN fluctuates, it provides a steady stream of income, which can appeal to income-oriented investors. This is because the coupon payments on an FRN are typically made semi-annually, providing a predictable income stream.
Key considerations
While FRNs offer several advantages, knowing certain key considerations is important before investing in these bonds. These include credit risk, interest rate sensitivity, and call provisions.
Credit risk. As with any bond, the issuer’s creditworthiness is crucial. A lower-rated issuer may offer a higher spread to compensate investors for the increased risk.
Interest rate sensitivity. While FRNs can somewhat mitigate interest rate risk, they are still sensitive to interest rate movements.
Call provisions. Some FRNs have call provisions, which allow the issuer to redeem the bond before its maturity date. This can limit the potential for capital appreciation if interest rates decline.
Conclusion
Floating-rate notes offer a unique investment opportunity with the potential for both income and capital appreciation. By understanding how FRNs work and considering the factors influencing their performance, investors can decide whether these bonds suit their investment goals.
However, it’s crucial to remember that FRNs are not without risk. Factors such as credit risk, interest rate sensitivity, and call provisions can impact their performance. As with any investment, it’s advisable to conduct thorough research or consult with a financial advisor to assess the suitability of FRNs for your specific investment objectives.