Floating-Rate Notes (also known as 'Floaters' or FRNs) are a special type of bond whose interest payments are not set in stone. Instead of a fixed, predictable income stream, the interest rate (or coupon rate) on a floater adjusts periodically based on a pre-set formula. Think of it as a chameleon of the bond world, changing its colors to match the surrounding economic environment. This is the direct opposite of a traditional fixed-rate bond, which pays the same coupon amount year after year, regardless of what happens in the market. The genius of an FRN lies in its ability to protect investors when interest rates are on the rise. Because its coupon payments “float” upwards with market rates, its price tends to be much more stable than that of a fixed-rate bond, which gets clobbered when rates climb.
Imagine you lent money to a friend, but instead of agreeing on a 5% interest rate for the life of the loan, you agreed on “whatever the bank offers on its best savings account, plus an extra 1% for my trouble.” As the bank's rates go up and down, so does the interest your friend pays you. That, in a nutshell, is a floating-rate note.
The coupon payment for a floater is determined by a simple and transparent formula: Coupon Rate = Benchmark Rate + Spread
The coupon rate isn't adjusted daily. It “resets” at regular, predetermined intervals—typically every three or six months. On each reset date, the issuer looks at the current level of the benchmark rate, adds the fixed spread, and that becomes the new coupon rate until the next reset. Example: You own an FRN that pays SOFR + 1.5% and resets quarterly.
Value investors are famously cautious and prize capital preservation. While often focused on finding undervalued companies, managing the cash and fixed-income portion of a portfolio is crucial. This is where floaters can shine.
This is the number one reason to own FRNs. When central banks like the Federal Reserve or the European Central Bank raise rates to fight inflation, holders of long-term, fixed-rate bonds suffer because the value of their bonds falls. Why would anyone pay full price for your old 3% bond when they can buy a new one paying 5%? FRNs sidestep this problem. As rates rise, their coupon payments also rise, keeping their market value relatively stable. They have very low interest rate risk, making them a powerful defensive tool in an inflationary environment.
Value investors often hold cash while waiting for the perfect, undervalued stock to appear (what Benjamin Graham called “Mr. Market” having a tantrum). Instead of letting that cash get eaten away by inflation in a low-yield savings account, FRNs issued by high-quality corporations or governments can offer a superior yield. They provide a way to earn a decent, inflation-protected return without the volatility of the stock market, keeping your “dry powder” productive while it waits.
No investment is without risk, and floaters are no exception. While they solve the interest rate risk problem, other dangers lurk.