Floating-Rate Note

A floating-rate note (FRN) is a bond that does not pay a fixed coupon. Instead, its coupon resets every three or six months to a benchmark rate (SOFR, SONIA, etc.) plus a fixed spread. If SOFR is 4% and the spread is 1%, the coupon is 5% for the next quarter. When SOFR rises to 5%, the coupon jumps to 6%. When SOFR falls, the coupon falls. From the investor’s perspective, a floating-rate note eliminates interest-rate risk — as rates rise, your coupon rises to keep pace, so the price stays near par. From the issuer’s perspective, FRNs shift duration risk to lenders and allow the issuer to refinance at current market rates. Floating-rate notes are the inverse of fixed-rate bonds: useful when you expect rising rates and want to avoid the price losses that hit fixed-coupon bond holders.

Why floating rates eliminate interest-rate risk

A fixed-rate bond at 4% falls in value if rates rise to 5%, because new bonds offer 5% and yours only pays 4%. But a floating-rate note adjusts immediately. When rates rise from 4% to 5%, your next coupon payment rises to SOFR (now 5%) plus your spread. Your coupon is competitive, so the bond’s price stays near par. This is why FRNs have very low duration — near zero. The price does not fluctuate with interest rate changes because the coupon adjusts. An investor who fears rising rates but does not want to give up yield can own a portfolio of floating-rate notes and sleep soundly—coupons rise with rates.

Structure of a typical FRN

• Reference rate: SOFR, SONIA, EURIBOR, or another benchmark.
• Spread: A fixed adjustment above the reference rate (e.g., +100 basis points). This spread never changes.
• Reset frequency: How often the coupon adjusts, typically quarterly (3-month reset) or semi-annually (6-month reset).
• Floor and cap (optional): Some FRNs have a minimum coupon (floor) or maximum coupon (cap) to limit the issuer’s or investor’s downside.

For example: An FRN might reset quarterly to 3-month SOFR + 150 bps, with a 1% floor. If 3-month SOFR is 2%, the coupon is 3.50% (2% + 1.50%), but not less than 1% (the floor). If SOFR is 0.5%, the coupon is still 1% due to the floor.

When and why companies issue FRNs

Companies issue floating-rate notes to:

• Reduce refinancing risk: The issuer’s cost moves with market rates, avoiding the risk of being locked into high fixed rates.
• Lower initial spread: FRNs often have tighter credit spreads than fixed-rate bonds because investors accept lower compensation for lower interest-rate risk.
• Appeal to banks and hedge funds: Short-term investors and interest-rate hedgers prefer FRNs.

During periods of high uncertainty about future rates, companies prefer issuing FRNs to avoid committing to high fixed rates. During stable, low-rate environments, companies prefer fixed-rate debt to lock in low costs.

Spread-lock and market conventions

When a company issues an FRN, the spread is fixed at issuance based on credit quality. A AAA-rated issuer might issue at SOFR + 50 bps, while a BB-rated issuer might issue at SOFR + 250 bps. This spread-lock is crucial: it allows the issuer to refinance at current rates while maintaining a predictable margin. Investors who buy the FRN at issuance lock in that spread for the bond’s life.

FRNs in a rising-rate environment

When rates rise, FRN investors prosper. Their coupons increase, and they are earning more than they would in fixed-rate bonds. The market value of FRNs stays near par, so they avoid the mark-to-market losses that fixed-bond holders suffer. This is why FRNs are popular with bond funds and insurers during periods when rates are expected to rise. In 2022, when the Federal Reserve aggressively hiked rates, FRNs outperformed fixed-rate bonds significantly.

FRNs in a falling-rate environment

When rates fall, FRN investors are hurt. Their coupons decline, and they are earning less. However, the price of the FRN does not rise (or rises very little) because the coupon adjusts down, keeping the yield competitive. This is the opposite of fixed-rate bonds, which rally when rates fall. If you own an FRN yielding SOFR + 150 bps and rates fall sharply, your coupon falls to SOFR (now 2%) + 150 bps = 3.50%. Meanwhile, a fixed-rate bond issued at 5.50% (when SOFR was 4%) still yields 5.50% and gains in price. For this reason, FRNs are not ideal for investors who expect falling rates and capital appreciation.

Floors and caps

Many FRNs have a floor (minimum coupon) to protect the issuer or investor:

• Investor floor: Protects the investor by setting a minimum coupon. If SOFR falls to 0.5%, a floor of 1% ensures the coupon is at least 1%.
• Issuer cap: Protects the issuer by capping the coupon. If SOFR rises to 10%, a cap of 6% limits the coupon to 6%.

These are embedded options and affect the bond’s value. An FRN with a wide floor and tight cap is less attractive to the investor because upside is capped and downside is protected only partially.

FRNs and LIBOR transition

Trillions of dollars in FRNs referenced LIBOR before its discontinuation. As LIBOR shut down, existing FRNs converted to SOFR, SONIA, or other replacement rates. The conversion required adding spread adjustments to ensure investors were not made better or worse off. Most new FRNs issued today reference SOFR, SONIA, or EURIBOR with stricter governance.

Valuation and duration

Because FRNs reset their coupons to market, they are priced very close to par (their face value). The duration is near zero if the reset frequency matches the investor’s holding period (e.g., quarterly reset, quarterly holding period). However, if you hold the FRN longer than the reset period, you gain some interest-rate risk because the coupon is fixed until the next reset. An FRN with a 3-month reset bought today and held until next quarter has near-zero duration; if held for 2 years with only a 3-month reset, it has some duration (the period until the next reset).

FRNs in portfolios

Fixed-income investors use FRNs to:

• Hedge interest-rate risk: Balance long-duration fixed-rate bonds with short-duration FRNs.
• Maintain yield in rising-rate environments: FRNs outperform when rates rise.
• Reduce duration: A portfolio of FRNs has minimal duration and is stable in price.

Conservative investors and money market funds hold FRNs for safety and stable returns as rates move. Speculators avoid FRNs when they expect falling rates because the price will not rally.