What it means
A floating-rate note, often shortened to FRN or "floater", pays interest that is recalculated at set intervals, most commonly every three months. The formula is written into the terms of the note: a reference rate plus a credit spread that reflects how risky the issuer is judged to be.
On each reset date the current reference rate is observed and the next coupon is fixed from it. The main attraction is protection against rising interest rates.
A fixed-rate bond loses market value when rates rise, because its now-stale coupon looks poor beside newly issued bonds. A floater simply pays more at the next reset, so its price tends to stay close to par.
Corporate treasurers sit on the other side of the same trade. Issuing a floater means borrowing costs track the market, which suits a business whose revenue also moves with the economic cycle.
Issuers who want certainty instead convert the floating payments into fixed ones using an interest rate swap. The protection is not complete, and this is where investors sometimes get caught out.
A floater still carries credit risk, and if the market decides the issuer has become riskier, the fixed spread baked into the note is no longer adequate compensation and the price falls. Some notes also carry caps or floors that limit how far the coupon can travel.
Reference rates themselves have changed considerably in recent years, as older interbank offered rates were retired in favour of overnight near-risk-free rates. Newer floaters typically reference a compounded overnight rate calculated in arrears, which means the exact coupon is only known near the end of the period rather than at the start.
The economics are broadly similar, but the mechanics and settlement timing differ.
In practice
Real-world examples
Example 1
A money market fund buys short-dated bank floaters rather than fixed-rate paper because it must return investors' cash at close to full value on demand. When central bank rates rise 1.5% over a year, the fund's income rises with them and the notes barely move in price.
Example 2
A utility issues $400,000,000 of five-year floating-rate notes to fund a construction programme, then enters a swap converting the payments to a fixed 5.1%. It gets the deep demand of the floater market while keeping the budget certainty its regulator expects.
Example 3
A corporate treasurer holding surplus cash for an eighteen-month period buys investment grade floaters instead of fixed-rate bonds. Rates end up falling, so the portfolio earns less interest than a fixed alternative would have, but the treasurer accepts that as the cost of near-certain principal value on the redemption date.
Think of it
A floating rate note is like renting a property with a variable rent linked to the local market index, rather than a fixed lease. If local property prices drop, your rent goes down. If the market heats up, your rent increases.
Formula
Calculation
Coupon Payment = Notional x (Reference Rate + Spread) x Days in Period / 360
An investor buys $1,000,000 face value of a three-year floating-rate note that pays quarterly at the reference rate plus a spread of 1.30%, using a 90/360 day count convention.
In the first quarter the reference rate is set at 4.20%, so the coupon rate is 4.20% + 1.30% = 5.50% and the payment is $1,000,000 x 0.0550 x 90 / 360 = $13,750. In the second quarter the reference rate rises to 4.80%, giving a coupon rate of 6.10% and a payment of $1,000,000 x 0.0610 x 90 / 360 = $15,250. In the third quarter rates fall sharply to 3.00%, so the coupon rate is 4.30% and the payment is $1,000,000 x 0.0430 x 90 / 360 = $10,750.
Across those three quarters the note pays $13,750 + $15,250 + $10,750 = $39,750. A fixed-rate bond locked at 5.50% would have paid $13,750 x 3 = $41,250, so the floater delivered $41,250 - $39,750 = $1,500 less over the period. That is the honest trade-off: the floater gave up income when rates fell, in exchange for keeping its price near par throughout.Case study
Seen in the real world
This is an illustrative, fictional scenario. Kingsmere Regional Bank, an invented mid-size lender, held $250,000,000 of fixed-rate government bonds as its liquidity buffer. When market rates rose by 2.5% over eighteen months, the market value of that portfolio fell by roughly $22,000,000, which was uncomfortable even though the bonds would repay at par if held to maturity.
The treasury team restructured, moving $150,000,000 into floating-rate notes issued by highly rated banks and government agencies. Over the following year rates rose a further 0.75%, and the floater portfolio's coupons rose with them while its market value stayed within about 0.4% of par. The fixed-rate remainder fell in value again.
The illustrative lesson is that floaters trade interest rate risk for reinvestment risk. Kingsmere's income would have been higher if rates had fallen instead, but the bank had decided that price stability in its liquidity buffer mattered more than squeezing out extra yield.
Watch out
Common mistakes
- Believing a floating-rate note is risk-free. It removes most interest rate price risk but keeps credit risk in full, and a floater from a deteriorating issuer can fall well below par.
- Confusing the spread with the coupon. The spread is the fixed add-on set at issue and does not change, while the coupon changes at every reset as the reference rate moves.
- Expecting a floater to outperform in every environment. When rates fall, a floater's income drops immediately, and a fixed-rate bond bought earlier would have produced both higher income and a capital gain.
Questions
People also ask
Why does a floating-rate note trade near par?
Because its coupon resets to current market levels every few months, there is little gap between what it pays and what a newly issued note would pay, so there is little reason for the price to drift far from face value.
What is a reset date?
It is the scheduled date on which the reference rate is observed and the next period's coupon is fixed, typically every one, three or six months depending on the terms.
Who issues floating-rate notes?
Banks are the largest issuers, followed by governments, agencies and corporates, particularly those whose own income or assets already move with short-term interest rates.