Floating-Rate Notes (FRNs)
Floating-Rate Notes (FRNs)
Floating-Rate Notes are US government securities with a twist: instead of a fixed coupon, they pay a floating coupon that resets quarterly based on the latest 13-week T-bill rate. An FRN might be structured as "13-week T-bill rate + 0.5%." Each quarter, the coupon resets to whatever the new T-bill rate is, plus 0.5%. As rates rise, your coupon rises; as rates fall, your coupon falls. This design shields you from interest-rate risk—FRNs trade very close to par and rarely fall more than 1–2% below par—while exposing you to reinvestment risk in falling-rate environments.
Key takeaways
- FRNs have coupons that reset quarterly based on the 13-week T-bill rate plus a fixed spread
- Duration is near zero because coupon resets offset interest-rate changes; prices stay close to par
- FRNs are ideal for investors expecting rising rates or uncertain about future rate paths
- The spread above the T-bill rate (called the "spread" or "discount margin") is the key determinant of value
- FRN yields are attractive in high-rate environments but fall when T-bill rates fall
How floating-rate notes work
A typical FRN issued by the Treasury is structured as follows:
- Maturity: 2 years (most common)
- Coupon reset: quarterly
- Coupon formula: 13-week T-bill rate + 0.25% (or 0.50%, or 0.75%)
- Par: $1,000 (or $100 for small face values)
When you hold the FRN, your coupon payment reflects the latest 13-week T-bill rate at the time of reset. In Q1 2024, if the 13-week T-bill rate is 5.30% and the spread is 0.25%, your quarterly coupon is 1.3875% of par (5.55% annualized). In Q2 2024, if the T-bill rate has risen to 5.50%, your quarterly coupon rises to 1.4375% (5.75% annualized).
The key insight: because your coupon resets quarterly to the prevailing market rate, the FRN's price stays very close to par. If rates have risen, you'd normally expect the bond's price to fall, but the higher coupon offsets this, keeping the price near par. Conversely, if rates fall, the lower coupon is offset by price appreciation. This near-zero duration characteristic is the defining feature of FRNs.
Duration near zero and price stability
A 2-year fixed-rate Treasury note with a 4% coupon has a duration of roughly 1.9 years. A 1% rise in yields causes the price to fall about 1.9%. An FRN of the same maturity has a duration of near zero, meaning a 1% rise in yields causes the price to fall only 0.1–0.3%—a negligible amount.
Why? Because the coupon resets to the new market rate, there is no "old coupon vs. new rate" mismatch. You always hold a bond yielding approximately the market rate, so its market value stays near par.
This price stability is valuable in volatile rate environments. If you're uncertain whether the Fed will raise or cut rates over the next two years, an FRN eliminates the guessing game. Your returns will track the T-bill rate up or down, with no surprises.
Spread above the T-bill rate
The spread—the fixed "plus" amount above the 13-week T-bill rate—is the only true fixed component of an FRN. When the Treasury issues a new FRN, it determines the spread based on supply and demand. In 2024, the Treasury issued 2-year FRNs with spreads of 0.25% to 0.50% above the T-bill rate.
This spread compensates you for:
- Credit risk (minimal for US Treasuries, but non-zero)
- Liquidity (FRNs are less liquid than fixed-rate notes, so there's a small liquidity premium)
- Reinvestment rate risk (if you need to sell before maturity, the price might be slightly off par)
As an FRN investor, your minimum return is the spread over the T-bill rate. If the spread is 0.5% and the T-bill rate averages 4%, you earn roughly 4.5% per year. If the T-bill rate averages 3%, you earn 3.5%. The spread is your "insurance"—it's what you earn even if rates fall sharply.
FRNs vs. fixed-rate bonds: when to choose each
Choose FRNs if:
- You expect rates to rise or are uncertain about future rates
- You want minimal price volatility in your bond allocation
- You prefer a "don't think too hard" approach (just earn the T-bill rate plus spread)
Choose fixed-rate bonds if:
- You expect rates to fall significantly
- You want to lock in a specific yield
- You're comfortable with price volatility for the upside of capital gains when rates fall
In mid-2024, with 2-year fixed notes yielding 4.7% and 2-year FRNs yielding roughly the 13-week T-bill rate (~5.3%) plus spread (~0.3%), FRNs offer slightly higher yields. The trade-off: if rates fall sharply to 3%, your FRN yield also falls to 3.3%, while a fixed 4.7% note locks in that return. Both approaches have merit; the choice depends on your outlook.
Treasury FRN auctions and market size
The Treasury has issued FRNs sporadically. In 2013, the Treasury issued a small amount (billions, not tens of billions) to understand demand. Since then, FRN issuance has been limited compared to fixed-rate notes. The market for Treasury FRNs is thus thinner than the fixed-rate market, meaning bid-ask spreads are wider (perhaps $1–$2 per $1,000 par versus $0.25–$0.75 for fixed notes).
This lower liquidity is the main drawback of Treasury FRNs. If you need to sell before maturity, you might face wider spreads or difficulty executing a large trade. For buy-and-hold investors, this is a minor concern; for tactical traders, it's a consideration.
Buying FRNs
FRNs are available through most brokerages and can be bid for at auction through TreasuryDirect. Because Treasury FRN issuance is limited, supply and availability fluctuate. At any given time, only a few FRN series may be on the market. A brokerage can help you identify available FRNs and execute trades in the secondary market.
The minimum purchase is $100 (at TreasuryDirect) and often higher at brokerages due to the thinner market. Bid-ask spreads are wider than fixed-rate Treasuries, so small positions may not be worth the spread; FRNs are better suited to allocations of $10,000 or more.
FRN yields and the term premium
When T-bill rates are elevated (as in 2024), FRN yields are attractive in absolute terms. A 2-year FRN yielding 5.5% (T-bill rate of 5.25% plus 0.25% spread) competes with 2-year fixed notes yielding 4.7%. The difference is 0.8%, a meaningful gap that reflects the option value of the floating coupon. In declining-rate environments, that optionality is valuable.
Conversely, when T-bill rates are very low (as in 2020–2021), FRN yields collapse because they reset lower. A 2-year FRN yielding 0.2% (T-bill rate of near-zero plus 0.2% spread) is unattractive. Investors then prefer fixed-rate bonds, even at near-zero yields, because they at least lock in the current yield; with FRNs, they'd be exposed to falling rates with no coupon floor.
Reinvestment risk and coupon variability
FRNs shift reinvestment risk onto the Treasury (or rather, onto the market). With a fixed-rate bond yielding 4%, you know you'll earn 4% per year. With an FRN yielding T-bill + 0.5%, your annual return is uncertain—it depends on future T-bill rates. If T-bill rates fall to 2%, your FRN yield falls to 2.5%, a 1.5% annual loss compared to your initial 5.5% yield (assuming you started at that level).
This uncertainty is a feature, not a bug, if you expect rates to remain high or rise. Your FRN yield moves up with rates, protecting your income. But in a declining-rate environment, FRN yields offer diminishing returns, making fixed-rate bonds more attractive in hindsight.
FRNs in portfolio construction
FRNs are a niche holding for most investors. A typical 60-40 portfolio might allocate 30% to bonds, split as 15% fixed-rate Treasuries, 5% TIPS, 5% corporate bonds, and 5% cash equivalents. FRNs are not explicitly allocated because they're rare and less liquid than alternatives.
However, in a rising-rate environment or when investors expect high volatility in rates, FRNs become more attractive. A conservative investor expecting the Fed to maintain high rates might allocate 5–10% to FRNs, replacing some fixed-rate short-term bonds. The higher and less volatile income from FRNs justifies the reduced liquidity.
The case for FRNs: protection in uncertain rate environments
The strongest case for FRNs is when the Fed's future rate path is genuinely uncertain. In early 2022, the Fed was beginning to raise rates, but the terminal rate (the peak rate) was unclear. Investors who bought 2-year FRNs locked in the ability to earn rising yields as the Fed moved, while also limiting downside if rates peaked and began falling. FRNs offered an "option" to participate in rising yields while maintaining price stability.
By late 2023, with the Fed's rate hikes seemingly over, the case for FRNs weakened. Investors believed rates would either hold steady or fall, making fixed-rate bonds more attractive. The opportunity cost of not locking in a 4.7% yield on a 2-year fixed note became apparent.
Tax treatment of FRNs
FRN interest is subject to federal income tax but exempt from state and local income tax, like all Treasuries. The coupon resets quarterly, and you owe federal tax on each coupon payment as you receive it. If you buy a discounted FRN in the secondary market and hold it to maturity, you also owe tax on the capital gain.
In high-tax states, the state-tax exemption on FRN coupons is valuable, as with all Treasuries. In tax-deferred accounts, FRN taxation is irrelevant.
Alternatives to FRNs: money-market funds and variable-rate CDs
If you want floating-rate exposure, FRNs are one option. Others include:
- Money-market funds: These hold T-bills and other short-term instruments, with net asset values that track the T-bill rate. A fund like Vanguard Treasury Money Market Fund (VMFXX) offers effective floating-rate exposure with minimal price volatility.
- Variable-rate CDs: Banks issue CDs with rates tied to the T-bill rate or prime rate. These offer FDIC insurance (up to $250,000) and floating-rate exposure, though with lower yields than Treasury FRNs.
- Short-term Treasury ETFs: Vanguard Short-Term Treasury ETF (VGSH) holds Treasuries with durations under 3 years, offering low interest-rate risk and current market yields.
For most investors, a combination of short-term fixed Treasuries and a money-market fund achieves the same effect (stable yields, minimal price volatility, liquidity) as FRNs, with less hassle.
Conclusion: a specialized tool for rising-rate environments
Floating-Rate Notes are ideal for investors expecting rising rates or highly uncertain rate paths. They offer near-zero interest-rate risk, near-par pricing, and yields that track the 13-week T-bill rate. However, their limited availability, wider bid-ask spreads, and falling yields in declining-rate environments make them niche holdings. For most portfolios, short-term fixed-rate Treasuries (2–5 year notes) or Treasury bond funds capture the same defensive characteristics while offering better liquidity and pricing.
FRN suitability matrix
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