Floating-Rate Notes (Floaters)

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 Benchmark Rate: This is the “floating” part of the equation. It's a well-known, independent interest rate that serves as the foundation. Common benchmarks include SOFR (Secured Overnight Financing Rate) in the U.S. or EURIBOR (Euro Interbank Offered Rate) in Europe. This benchmark reflects the current cost of borrowing in the wider financial system.
• The Spread: This is the “fixed” part of the formula, representing the extra slice of pie you get for taking on the risk of lending to a specific entity. The spread is expressed in percentage points (or basis points) and is fixed for the life of the note. It directly reflects the credit risk of the issuer. A blue-chip company with a stellar credit rating might pay a small spread, while a riskier company will have to offer a much larger spread to entice investors.

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.

• At the start of Q1, SOFR is 3.0%. Your coupon for that quarter will be 4.5% (on an annualized basis).
• If, by the start of Q2, the central bank has raised rates and SOFR is now 3.5%, your coupon automatically resets to 5.0% for the next quarter.

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.

• Credit Risk: This is the primary risk. The spread is your compensation for the chance that the issuer could go bust and fail to pay you back. If the company or government that issued the FRN gets into financial trouble, the value of your note will fall, and you could lose your entire investment. Always check the issuer's creditworthiness with agencies like Moody's or S&P Global Ratings.
• Spread Risk: The spread is fixed when you buy the note. If the market's perception of the issuer's riskiness worsens over time, new floaters from that same issuer will be forced to offer a higher spread. This makes your note with its lower, “locked-in” spread less attractive, and its market price could fall.
• Tricky Features (Caps, Floors, and Calls): Always read the fine print in the bond's prospectus! Some FRNs come with features that can trip you up.

1. Caps: A maximum rate the FRN will ever pay. This limits your upside if rates go through the roof.
2. Floors: A minimum rate the FRN will pay. This protects you if benchmark rates fall to zero.
3. Call Provisions: This gives the issuer the right to buy back the note from you before its maturity date. They will almost certainly do this when it benefits them (e.g., their credit has improved and they can borrow more cheaply), which is precisely when you'd want to keep holding the note.