Floating-Rate Note (FRN)

A Floating-Rate Note (FRN), often called a 'floater', is a type of bond or debt security whose interest payments are not fixed for its entire life. Unlike a traditional bond with a static coupon rate, an FRN’s interest payment periodically resets based on an underlying benchmark rate, such as the SOFR (Secured Overnight Financing Rate) in the U.S. or EURIBOR (Euro Interbank Offered Rate) in Europe. To compensate investors for the issuer's credit risk, a fixed additional percentage, known as the spread (or quoted margin), is added to this benchmark. The total interest payment is therefore calculated as Benchmark Rate + Spread. This clever mechanism is designed to minimize interest rate risk. As prevailing market interest rates rise, so does the FRN’s coupon payment, which helps keep the note's market price highly stable and close to its original par value. This makes it a popular instrument during periods of monetary tightening.

The magic of an FRN lies in its two-part coupon. By separating the general level of interest rates from the issuer-specific risk premium, it creates a flexible instrument that adapts to changing economic conditions.

An FRN’s interest payment is determined by three key components:

• The Benchmark Rate: This is the 'floating' part of the equation. It's a variable, external reference rate that reflects the current cost of borrowing in the wider market. Common benchmarks include government borrowing rates (like the U.S. Treasury bill auction rate) or interbank lending rates (like SOFR or EURIBOR).
• The Spread: This is the 'fixed' part. It is a set percentage added to the benchmark rate, determined when the FRN is first issued. The spread is essentially the investor's reward for taking on the credit risk of the issuer. A financially sound blue-chip company will pay a lower spread than a riskier, smaller business.
• The Reset Date: The interest rate isn't adjusted daily. It is reset at regular, predetermined intervals, such as every three months (quarterly) or six months (semi-annually). The benchmark rate on this specific 'reset date' is used to calculate the coupon for the next payment period.

Imagine you purchase a 5-year FRN issued by “Stable Corp.” with the following terms:

1. Par Value: $1,000
2. Benchmark: 3-Month SOFR
3. Spread: +1.25% (or 125 basis points)
4. Reset Schedule: Quarterly

At the first quarterly reset date, the 3-Month SOFR is 4.0%. Your coupon for the next three months will be calculated at an annualized rate of: 4.0% (SOFR) + 1.25% (Spread) = 5.25% Now, suppose the central bank raises interest rates. Three months later, at the next reset date, the 3-Month SOFR has climbed to 4.5%. Your coupon for the following quarter automatically adjusts upwards: 4.5% (SOFR) + 1.25% (Spread) = 5.75% This automatic adjustment protects your income stream from being eroded by inflation and rising rates.

For a value investor, an FRN is not a tool for speculation but for defense. The focus shifts from predicting interest rates to analyzing the underlying credit quality of the issuer.

• Interest Rate Protection: This is the star feature. In a rising-rate environment, the value of fixed-rate bonds falls because their locked-in coupons become less attractive. FRNs, by adjusting their coupons upwards, largely sidestep this problem, making them excellent tools for capital preservation.
• Price Stability: Because the coupon floats with the market, an FRN's price tends to hover very close to its par value. This significantly reduces price risk compared to other bonds of similar maturity.
• Higher Yield than Cash: FRNs typically offer a better return than cash sitting in a bank account or a money market fund, providing a modest income stream with relatively low volatility.

• Credit Risk: This is the most significant risk for an FRN holder. While the coupon adjusts for market-wide rates, the spread is fixed. If the issuing company's financial health deteriorates, investors will demand a higher spread to lend to them. Since your FRN's spread is locked in, its market price will fall below par to compensate new buyers for the increased risk. A true value investor must always scrutinize the issuer's balance sheet and debt-servicing ability before buying. The risk of default is always present.
• Coupon Caps and Floors: Be wary of the fine print. Some FRNs come with a coupon cap, which sets a maximum interest rate the note will ever pay, limiting your potential gains in a hyper-inflationary scenario. Conversely, a coupon floor sets a minimum rate, protecting you if rates fall to zero. Always check the prospectus for these features.
• Liquidity Risk: While FRNs issued by governments and large corporations are generally easy to buy and sell, those from smaller, less-known entities can suffer from poor liquidity risk. This means you might have to sell at a discount if you need your cash back in a hurry.

FRNs are issued by a wide range of entities looking to manage their interest rate exposure or appeal to investors in an uncertain rate environment. Common issuers include:

• Governments: The U.S. Treasury, for instance, issues FRNs to fund its operations.
• Corporations: Financial institutions like banks are major issuers, as FRNs help them match the interest rates on their assets (loans) with their liabilities (deposits and debt).
• Supranational Agencies: Organizations like the World Bank also use FRNs to raise capital in global markets.

Floating-Rate Notes are a defensive instrument in an investor's toolkit. They are not designed for spectacular growth but for protecting capital and generating a modest, inflation-hedged income, particularly when you believe interest rates are heading higher. For the value investor, the key is not to guess the direction of interest rates but to apply fundamental analysis to the issuer. An FRN is simply a loan—your primary job is to ensure you are lending to a reliable counterparty at a spread that fairly compensates you for the risk you are taking.