Floating Rate Note (FRN)

A floating rate note (FRN), also called a floater, is a bond whose interest payments change over time. Instead of paying a set coupon rate, it pays a short-term reference rate plus a fixed margin, and the rate is reset at regular intervals, often every three months. Governments, banks, companies and supranational lenders issue FRNs, and investors buy them when they want income that keeps pace with changing interest rates.

FRNs are the floating counterpart of conventional bonds paying a fixed interest rate. Because the coupon adjusts to market conditions, an FRN's price usually stays close to its par value, which makes it attractive to cash-rich investors such as money market funds and corporate treasurers. Before 2023 most FRNs were linked to LIBOR; today the main references are overnight rates such as SOFR in US dollars, SONIA in sterling and €STR or EURIBOR in euros, along with local benchmarks such as KIBOR in Pakistan.

A fixed-rate bond is like renting a flat at a rent agreed for many years: if rents in the area jump, you still pay the old rate, and if they fall, you are stuck paying more than the going price. A floating rate note is like a lease where the rent is updated every few months to match the local market, plus a small fixed extra for the landlord.

For the lender, that means the income goes up when rates go up and down when they go down. The value of the note does not swing much, because it never drifts far from what a new note would pay.

Each period the coupon is fixed by adding the quoted margin to the reference rate observed at the reset date. For a note paying quarterly on an actual/360 day count, the payment is:

• $N$ is the face (principal) amount of the note.
• $R$ is the reference rate for the period, as a decimal.
• $m$ is the fixed quoted margin over the reference rate.
• $d$ is the number of days in the interest period.

Suppose a bank issues an FRN with a face amount of 1,000,000 paying the reference rate plus 0.50%, and the reference rate is 4.00% for a 90-day period. The coupon for that quarter is $1{,}000{,}000 \times 0.045 \times 90 \div 360 = 11{,}250$. If the reference rate falls to 3.00% at the next reset, the following quarter's payment drops to $1{,}000{,}000 \times 0.035 \times 90 \div 360 = 8{,}750$. The margin, often quoted in basis points, is set at issue to reflect the issuer's credit quality and stays the same for the life of the note.

• Governments. The US Treasury began auctioning two-year FRNs in January 2014; their rate is linked to the 13-week Treasury bill auction rate plus a spread fixed at auction, with interest paid quarterly. They form part of the wider stock of Treasury securities. In Pakistan, the government issues floating-rate Pakistan Investment Bonds whose coupons are linked to Treasury bill yields.
• Banks. Banks issue FRNs to fund floating-rate loans, so that interest on their funding moves in step with interest on their assets.
• Companies and supranationals. Corporate borrowers and development banks issue FRNs in domestic markets and as Eurobonds.
• Securitization vehicles. Many tranches of mortgage-backed and asset-backed debt created through securitization pay floating coupons.

Variations include capped FRNs, which limit the maximum coupon; floored FRNs, which guarantee a minimum; collared notes with both; and inverse floaters, whose coupon falls when the reference rate rises.

The main appeal of an FRN is low interest rate risk. Because the coupon resets, the note's price changes little when rates move; its sensitivity is roughly that of an instrument maturing at the next reset date. That makes FRNs useful for investors who expect rising rates or who need to match floating-rate liabilities. Issuers and investors can also convert fixed payments into floating ones, or the reverse, with an interest rate swap, or lock in a single future rate with a forward rate agreement.

FRNs still carry other risks:

• Credit risk. The margin is fixed at issue, so if the issuer's credit spread widens later, the note trades below par. This credit risk is the main driver of FRN price moves.
• Income risk. When central banks cut rates, the holder's income falls, unlike a fixed-rate holder whose coupon is locked in.
• Benchmark risk. The end of LIBOR showed that a reference rate can disappear. Notes needed fallback language to move to a replacement rate, and some older contracts required legislation in the US and UK to transition.

An FRN also differs from a zero-coupon bond, which concentrates all of its rate sensitivity in a single distant payment, and from conventional government bonds, whose fixed coupons lose value when rates rise.

• TreasuryDirect: Floating Rate Notes
• Federal Reserve Bank of New York: SOFR