A floating-rate note, also known as a floater or FRN, is a debt instrument with a variable interest rate. A floating rate note’s interest rate, since it is not fixed, is tied to a benchmark such as the U.S. Treasury bill rate, LIBOR, the Fed funds or the prime rate. Floaters are mainly issued by financial institutions and governments, and they typically have a two- to five-year term to maturity.
1:21 Floating-Rate Note BREAKING DOWN Floating-Rate Note - FRN
Floating-rate notes (FRNs) make up a significant component of the U.S. investment-grade bond market, and they tend to become more popular when interest rates are expected to increase. Compared with fixed-rate debt instruments, floaters protect investors against a rise in interest rates. This is because interest rates have an inverse relationship with bond prices, and the market price for a fixed-rate note will drop if interest rates increase. For this reason, however, FRNs carry lower yields than fixed notes of the same maturity. They also have unpredictable coupon payments, although the note sometimes has a cap and a floor, which allows an investor to know the maximum and/or minimum interest rate the note might pay.
An FRN& interest rate can change as often or as frequently as the issuer chooses, from once a day to once a year. The reset period tells the investor how often the rate adjusts. The issuer may pay interest monthly, quarterly, semiannually or annually. FRNs may be issued with or without a call option.
One major FRN issuer is Fannie Mae. Its FRNs have different reference rates, including three-month T-bills, the prime rate, Fed funds rate, one-month LIBOR and three-month LIBOR. Commercial banks, state and local governments, corporations and money market funds purchase these notes, which offer a variety of terms to maturity and may be callable or non-callable.
Examples of a Floating Rate Note
The most common type of FRN is one issued by the federal government. For example, the U.S. government announced on July 21, 2016, that it would issue $15 billion worth of two year FRNs. The notes became available on July 27, 2016.
However, the government is not the only type of entity that can offer such notes. For example, Guaranty Bancorp, a community bank holding company based in Denver, completed a $40 million offering of fixed-to-floating rate notes on July 18, 2016. The notes carry a fixed annual rate of 5.75% until July 20, 2021. After that date, the notes are to carry a quarterly floating rate equal to the three-month LIBOR as determined by the specific quarterly period, plus 4.73%. This means that the reset period is quarterly.