Contents
Floating-rate notes (FRNs) offer a distinctive advantage over traditional fixed-rate bonds. Instead of a static interest rate throughout their lifespan, FRNs dynamically adjust their interest payments to reflect changes in a specific benchmark rate. This unique feature protects investors against the potential erosion of their bond’s value in a rising interest rate environment.
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 a floating-rate note (FRNs) 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 benchmark interest rate, such as LIBOR or SOFR, is used to determine the initial interest rate. It can fluctuate over time, impacting the coupon payments on the floating-rate note (FRN). For example, if the reference rate rises, the coupon rate will also increase, providing some protection against rising interest rates.
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. The spread reflects the issuer’s creditworthiness; lower-rated issuers typically offer higher spreads to compensate investors for the increased risk.
Principal amount. This is the face value of the bond, which is the amount the issuer promises to repay at maturity. It is also used to calculate the coupon payments.
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, 0.25 for a quarterly fee, or 1 for an annual payment. The coupon payment is typically calculated by multiplying the coupon rate by the principal amount and the time period.
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.
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 floating-rate notes (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, such as a company with a lower credit rating from agencies like Moody’s or S&P, may offer a higher spread to compensate investors for the increased risk of default. If the issuer’s financial condition deteriorates, their ability to make timely interest and principal payments may be compromised, potentially leading to investor losses.
Interest rate sensitivity. While FRNs can somewhat mitigate interest rate risk by adjusting their coupon payments, they are still sensitive to interest rate movements. Changes in the overall level of interest rates can impact the value of the underlying reference rate, affecting the FRN’s coupon rate. Additionally, even with adjusting coupon payments, the market price of an FRN can still fluctuate due to changes in investor sentiment, credit quality, and overall market conditions.
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. If interest rates fall significantly, the issuer may call the bond and issue new debt at a lower interest rate, effectively locking the higher coupon rate for existing bondholders. This can limit the potential for investors to benefit from the lower interest rate environment.
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. 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.
⬡ Start Your Journey Here: Fixed Income Instruments.
