Floating-Rate Notes (FRNs)

Floating-Rate Notes (also known as 'floaters') are a clever type of Bond that acts like a chameleon in the world of interest rates. Unlike a traditional bond with a fixed-for-life payment, an FRN’s Interest Rate payment—its Coupon—isn't set in stone. Instead, it periodically adjusts to follow the ups and downs of a specific financial benchmark. Think of it as a financial instrument with a built-in thermostat, automatically adjusting the heat (your income) to match the room temperature (prevailing interest rates). The coupon is typically calculated by taking a widely recognized Benchmark Rate, such as the SOFR (Secured Overnight Financing Rate) in the United States or EURIBOR (Euro Interbank Offered Rate) in Europe, and adding a little extra on top. This “extra” is a fixed percentage called the Spread, which compensates the investor for the risk of lending to the Issuer. This dynamic nature makes FRNs a popular tool for investors who are wary of rising interest rates.

Imagine you're in a boat on a tidal river. A Fixed-Rate Bond is like tying your boat to a pole at a specific height; no matter how high the tide rises, your boat stays put. An FRN, on the other hand, is like letting your boat float freely; as the tide (interest rates) rises, so does your boat (your coupon payments). The magic lies in a simple formula: Coupon Rate = Benchmark Rate + Spread Let's break it down with an example. Suppose you buy an FRN issued by a company, with a coupon that resets every three months and is priced at “SOFR + 1%”.

• At the start of the period, the SOFR rate is 3%.
• Your coupon for the next three months will be 3% + 1% = 4% (annualized).
• Three months later, the central bank has raised rates, and SOFR is now 4.5%.
• At the reset date, your new coupon automatically adjusts to 4.5% + 1% = 5.5% (annualized).

The Spread (the 1% in our example) is the key. It's determined when the FRN is first issued and reflects the market's assessment of the issuer's Credit Risk. A rock-solid government might offer a very small spread, while a riskier corporation will have to offer a larger one to attract investors.

FRNs are a specific tool for a specific job. They shine in some environments and are less appealing in others. Understanding their pros and cons is crucial.

• Protection from Rising Rates: This is the headline benefit. When central banks are hiking rates to fight Inflation, owners of fixed-rate bonds watch in horror as the value of their holdings falls. FRN holders, meanwhile, see their income stream rise, protecting their investment from this specific pain.
• Low Interest Rate Risk: Because the coupon adjusts to market conditions, the price of an FRN tends to be incredibly stable. It rarely strays far from its face value (or par value). In bond jargon, this means it has a very low Duration, making it much less volatile than a fixed-rate bond of the same Maturity.
• Capital Preservation: The combination of a stable price and an adjusting coupon makes FRNs an excellent vehicle for preserving the real value of your capital, especially when you anticipate rising rates.

• Lower Payout in Falling Rate Environments: The flip side of protection is a lack of upside. If interest rates fall, your coupon payments will decrease with each reset. In this scenario, you'd have been much better off locking in a higher Yield with a fixed-rate bond.
• Credit Risk Never Disappears: The “float” only applies to interest rates, not to the issuer's quality. If the company or government that issued the FRN runs into financial trouble, its creditworthiness will decline, and the price of your FRN will fall, regardless of what interest rates are doing. You could still lose your Principal if the issuer defaults.
• Potential for Caps: Some FRNs come with a “cap,” which is a maximum interest rate they will ever pay. This can limit your potential income if rates were to skyrocket, so always check the fine print.
• Lower Overall Yield: The safety and stability of FRNs come at a price. They generally offer lower yields than fixed-rate bonds of similar credit quality and maturity, as you are giving up the potential for price appreciation in exchange for protection.

For a Value Investing practitioner, FRNs are less about hitting home runs and more about not striking out. The core tenet of value investing is the preservation of capital, and in an environment of rising interest rates, FRNs can be an invaluable defensive tool. They offer a place to park cash and earn a reasonable return that keeps pace with inflation and interest rate policy, without the significant price risk that hammers traditional bonds. However, a value investor wouldn't buy an FRN blindly. The focus shifts from forecasting interest rates to a fundamental analysis of two things:

1. The Issuer: Is the company or government financially sound? A value investor rigorously analyzes the issuer's balance sheet and income-generating power to ensure the probability of default is extremely low.
2. The Spread: This is where the opportunity lies. The spread is your compensation for taking on credit risk. A value investor seeks a “margin of safety” by finding FRNs where the offered spread is greater than the underlying risk warrants. This can happen during times of market panic when even high-quality issuers see their spreads widen temporarily.

Ultimately, FRNs are a specialized instrument. They are not a path to spectacular wealth, but they can be a shrewd and prudent component of a portfolio, providing stability and income protection when the economic seas get choppy.