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 traditional fixed-rate bonds, which pay the same interest amount year after year, an FRN’s interest payment, or coupon, isn't set in stone. Instead, it periodically adjusts, or “floats,” based on a specific short-term benchmark interest rate. Think of it as a loan that automatically updates its interest rate to keep pace with the market. This unique feature makes FRNs a popular tool for investors who are worried about rising interest rates. The coupon payment is calculated by taking the benchmark rate and adding a fixed margin on top, known as the spread. This spread is determined when the bond is first issued and compensates the investor for the credit risk of the issuer. So, when general interest rates go up, so does the income you receive from your FRN, and vice versa.

The magic behind an FRN's coupon is a simple addition problem.

• Coupon Rate = Benchmark Rate + Spread

The Benchmark Rate is a well-known, publicly available interest rate, such as the SOFR (Secured Overnight Financing Rate) in the U.S. or EURIBOR (Euro Interbank Offered Rate) in Europe. The Spread is an extra percentage added on top, which is your reward for lending to that specific company or government. For example, if SOFR is at 3% and the bond’s spread is 1.5%, your total coupon for that period would be 4.5%. This spread typically remains constant for the life of the bond.

Your FRN’s coupon doesn't change every single day. The rate is adjusted on predetermined reset dates, which are clearly stated when the bond is issued. Common reset periods are quarterly (every 3 months) or semi-annually (every 6 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 date. This periodic adjustment is what keeps the FRN’s market price relatively stable compared to its fixed-rate cousins.

The primary superpower of an FRN is its ability to protect you from interest rate risk. Here's the scenario: Imagine interest rates are rising.

• If you own a fixed-rate bond paying 3%, but new bonds are now being issued at 5%, your old bond suddenly looks a lot less attractive. Its market price will fall to compensate new buyers for its lower coupon.
• If you own an FRN, however, its coupon will automatically adjust upwards on the next reset date to reflect the new, higher rates. Because its income stream keeps up with the market, its price tends to stay much closer to its par value. This makes FRNs a fantastic tool for investors who anticipate a period of rising rates.

Of course, there’s no free lunch in investing. For the valuable protection they offer, FRNs come with a couple of trade-offs.

• Lower Yields: Because they have less interest rate risk, FRNs typically offer a lower initial yield than a fixed-rate bond from the same issuer with the same maturity. You are essentially paying for an insurance policy against rising rates.
• Caps and Floors: Many FRNs come with a coupon cap and a coupon floor. A floor sets a minimum interest rate, which is great for the investor if rates plummet. A cap, however, sets a maximum interest rate, which limits your potential income if rates skyrocket. It’s crucial to read the fine print to see if these limits exist.
• Falling Rates: In a falling rate environment, FRNs are less attractive. Your coupon payments will decrease at each reset, while a fixed-rate bond would have locked in the previously higher rate.

A true value investor is always focused on capital preservation and buying assets for less than their intrinsic worth. From this viewpoint, FRNs are less of a tool for generating spectacular returns and more of a strategic defensive play. A value investor might use FRNs not to speculate on the direction of interest rates, but to park cash productively while reducing the volatility of their overall bond portfolio. The key, as always, is to look past the fancy features and focus on the fundamentals. The most important factor remains the creditworthiness of the entity issuing the bond. An FRN from a financially weak company is still a high-risk investment, no matter how its coupon is structured. A rigorous credit analysis of the issuer's balance sheet and ability to meet its obligations is paramount. For a value investor, an FRN is only a good investment if it's issued by a strong, stable entity and purchased at a reasonable price, serving the purpose of protecting capital in an uncertain rate environment.