Floating rate notes (FRNs) are
bonds that have a variable
coupon
In marketing, a coupon is a ticket or document that can be redeemed for a financial discount or rebate when purchasing a product.
Customarily, coupons are issued by manufacturers of consumer packaged goods
or by retailers, to be used in r ...
, equal to a
money market
The money market is a component of the economy that provides short-term funds. The money market deals in short-term loans, generally for a period of a year or less.
As short-term securities became a commodity, the money market became a compon ...
reference rate A reference rate is a rate that determines pay-offs in a financial contract and that is outside the control of the parties to the contract. It is often some form of LIBOR rate, but it can take many forms, such as a consumer price index, a house pric ...
, like
LIBOR
The London Inter-Bank Offered Rate is an interest-rate average calculated from estimates submitted by the leading banks in London. Each bank estimates what it would be charged were it to borrow from other banks. The resulting average rate is u ...
or
federal funds rate
In the United States, the federal funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight on an uncollateralized basis. Reserve balances a ...
, plus a quoted spread (also known as quoted margin). The spread is a rate that remains constant. Almost all FRNs have quarterly coupons, i.e. they pay out interest every three months. At the beginning of each coupon period, the coupon is calculated by taking the fixing of the
reference rate A reference rate is a rate that determines pay-offs in a financial contract and that is outside the control of the parties to the contract. It is often some form of LIBOR rate, but it can take many forms, such as a consumer price index, a house pric ...
for that day and adding the spread.
A typical coupon would look like 3 months USD LIBOR +0.20%.
Issuers
In the
United States
The United States of America (U.S.A. or USA), commonly known as the United States (U.S. or US) or America, is a country primarily located in North America. It consists of 50 states, a federal district, five major unincorporated territorie ...
, banks and financial service companies have been among the largest issuers of these securities. The U.S. Treasury began issuing them in 2014, and
government sponsored enterprise
A government-sponsored enterprise (GSE) is a type of financial services corporation created by the United States Congress. Their intended function is to enhance the flow of credit to targeted sectors of the economy, to make those segments of the ...
s (GSEs) such as the
Federal Home Loan Banks
The Federal Home Loan Banks (FHLBanks, or FHLBank System) are 11 U.S. government-sponsored banks that provide liquidity to the members of financial institutions to support housing finance and community investment.
Overview
The FHLBank System was ...
, the
Federal National Mortgage Association (Fannie Mae) and the
Federal Home Loan Mortgage Corporation (Freddie Mac) are important issuers. In Europe, the main issuers are
bank
A bank is a financial institution that accepts deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital markets.
Because ...
s.
Variations
Some FRNs have special features such as maximum or minimum coupons, called "capped FRNs" and "floored FRNs". Those with both minimum and maximum coupons are called "collared FRNs".
"Perpetual FRNs" are another form of FRNs that are also called irredeemable or unrated FRNs and are akin to a form of capital.
FRNs can also be obtained synthetically by the combination of a
fixed rate bond
Fixed may refer to:
* ''Fixed'' (EP), EP by Nine Inch Nails
* ''Fixed'', an upcoming 2D adult animated film directed by Genndy Tartakovsky
* Fixed (typeface), a collection of monospace bitmap fonts that is distributed with the X Window System
* F ...
and an
interest rate swap
In finance, an interest rate swap (IRS) is an interest rate derivative (IRD). It involves exchange of interest rates between two parties. In particular it is a "linear" IRD and one of the most liquid, benchmark products. It has associations wit ...
. This combination is known as an asset swap.
* Perpetual notes (PRN)
* Variable rate notes (VRN)
* Structured FRN
* Reverse FRN
* Capped FRN
* Floored FRN
* Collared FRN
* Step up recovery FRN (SURF)
* Range/corridor/accrual notes
* Leveraged/deleveraged FRN
A deleveraged floating-rate note is one bearing a coupon that is the product of the index and a
leverage factor, where the leverage factor is between zero and one. A deleveraged floater, which gives the investor decreased exposure to the underlying index, can be replicated by buying a pure FRN and entering into a swap to pay floating and receive fixed, on a notional amount of less than the face value of the FRN.
Deleveraged FRN = long pure FRN + short (1 - leverage factor) x swap
A leveraged or super floater gives the investor increased exposure to an underlying index: the leverage factor is always greater than one. Leveraged floaters also require a floor, since the coupon rate can never be negative.
Leveraged FRN = long pure FRN + long (leverage factor - 1) x swap + long (leverage factor) x floor
Risks
Credit risk
Floating-rate notes issued by corporations, such as banks and financial firms, are subject to
credit risk
A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased ...
, depending on the credit-worthiness of the issuer. Those issued by the
U.S. Treasury
The Department of the Treasury (USDT) is the national treasury and finance department of the federal government of the United States, where it serves as an executive department. The department oversees the Bureau of Engraving and Printing and t ...
, which entered the market in 2014, are traditionally regarded as having minimal credit risk.
Interest rate risk
Opinion is divided as to the efficacy of floating-rate notes in protecting the investor from
interest rate risk
In finance and economics, interest is payment from a borrower or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum (that is, the amount borrowed), at a particular rate. It is distinc ...
. Some believe that these securities carry little
interest rate risk
In finance and economics, interest is payment from a borrower or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum (that is, the amount borrowed), at a particular rate. It is distinc ...
because 1) a floating rate note's Macaulay
Duration
Duration may refer to:
* The amount of time elapsed between two events
* Duration (music) – an amount of time or a particular time interval, often cited as one of the fundamental aspects of music
* Duration (philosophy) – a theory of time and ...
is approximately equal to the time remaining until the next interest rate adjustment; therefore its price shows very low sensitivity to changes in market rates; and 2) when market rates rise, the expected coupons of the FRN increase in line with the increase in forward rates, which means its price remains constant, as compared to fixed rate bonds, whose prices decline when market rates rise. This point of view holds that floating rate notes are conservative investments for investors who believe market rates will increase.
A somewhat different view is held by author Dr. Annette Thau: "The rationale for floaters is that as interest rates change, resetting the coupon rate... will tend to maintain the price of the bond at or close to par. In practice this has tended not to work out quite as well as had been hoped, for a number of reasons. First, during times of extreme interest rate volatility, rates are not reset quickly enough to prevent price fluctuations. Secondly, the coupon rates of floaters are usually well below those of long-term bonds and often not very attractive when compared to shorter maturity bonds."
Complexity
Commenting on the complexity of these securities, Richard S. Wilson of the credit rating firm Fitch Investors Services noted: "Financial engineers worked overtime on floating-rate securities and have created debt instruments with a variety of terms and features different from those of conventional fixed-coupon bonds....The major investment firms with their worldwide trading capabilities participate in these markets 24 hours a day. But floaters are complex instruments, and investors who don't understand them should stay away. This applies to individuals as well as institutional portfolio managers."
Trading
Securities dealers
make markets in FRNs. They are traded
over-the-counter
Over-the-counter (OTC) drugs are medicines sold directly to a consumer without a requirement for a prescription from a healthcare professional, as opposed to prescription drugs, which may be supplied only to consumers possessing a valid prescr ...
, instead of on a
stock exchange
A stock exchange, securities exchange, or bourse is an exchange where stockbrokers and traders can buy and sell securities, such as shares of stock, bonds and other financial instruments. Stock exchanges may also provide facilities for th ...
. In Europe, most FRNs are liquid, as the biggest investors are banks. In the U.S., FRNs are mostly held to maturity, so the markets aren't as liquid. In the wholesale markets, FRNs are typically quoted as a spread over the reference rate.
Example
Suppose a new 5 year FRN pays a coupon of 3 months LIBOR +0.20%, and is issued at par (100.00). If the perception of the credit-worthiness of the issuer goes down, investors will demand a higher interest rate, say LIBOR +0.25%. If a trade is agreed, the price is calculated. In this example, LIBOR +0.25% would be roughly equivalent to a price of 99.75. This can be calculated as par, minus the difference between the coupon and the price that was agreed (0.05%), multiplied by the maturity (5 year).
Yield measures
Metrics such as yield to maturity and internal rate of return cannot be used to estimate the potential return from a floating rate note. That is the case because it is impossible to forecast the stream of coupon payments with accuracy, since they are tied to a benchmark that is constantly subject to change. Instead, metrics known as the effective spread and the simple margin can be used.
Effective spread
The effective spread is the average margin over the benchmark rate that is expected to be earned over the life of the security. For a floating rate note selling at par value, the effective margin is merely the contractual spread over the benchmark rate specified in the note's prospectus.
For notes that sell at a discount or premium, finance scholar Dr. Frank Fabozzi outlines a present value approach: project the future coupon cash flows assuming that the benchmark rate does not change and find the discount rate that makes the present value of the future cash flows equal to the market price of the note. That discount rate is the effective spread. This approach takes into account the premium or discount to par value and the time value of money, but suffers from the simplifying assumption that holds the benchmark rate at a single value for the life of the note.
Simple margin
A simpler approach begins with computing the sum of the quoted spread of the FRN and the capital gain (or loss) an investor will earn if the note is held to maturity:
Second, adjust the above for the fact that the note is bought at a discount or premium to the nominal value:
See also
*
Fixed rate bond
Fixed may refer to:
* ''Fixed'' (EP), EP by Nine Inch Nails
* ''Fixed'', an upcoming 2D adult animated film directed by Genndy Tartakovsky
* Fixed (typeface), a collection of monospace bitmap fonts that is distributed with the X Window System
* F ...
*
Structured note A structured note is an over the counter derivative with hybrid security features which combine payoffs from multiple ordinary securities, typically a stock or bond plus a derivative.
When the product depends on a credit payoff, it is called a cr ...
**
Equity-linked note
An equity-linked note (ELN) is a debt instrument, usually a bond, that differs from a standard fixed-income security in that the final payout is based on the return of the ''underlying equity'', which can be a single stock, basket of stocks, or an ...
**
Inverse floating rate note
An inverse floating rate note, or simply an inverse floater, is a type of Bond (finance), bond or other type of debt instrument used in finance whose Coupon (bond), coupon rate has an inverse relationship to short-term interest rates (or its refere ...
**
Credit-linked note A credit-linked note (CLN) is a form of funded credit derivative. It is structured as a security with an embedded credit default swap allowing the issuer to transfer a specific credit risk to credit investors. The issuer is not obligated to repay th ...
**
Market-linked note
A structured product, also known as a market-linked investment, is a pre-packaged structured finance investment strategy based on a single security, a basket of securities, options, indices, commodities, debt issuance or foreign currencies, and t ...
References
{{DEFAULTSORT:Floating Rate Note
Bonds (finance)
Interest-bearing instruments