BAJAJ BROKING
February 11, 2025
6 mins read
In this blog, we will discuss Floating-Rate Notes, FRNs, and how they work. We will talk about the risks associated with them, and go over their pros and cons. We will also look at an example for FRNs.
FRNs, or Floating-Rate Notes, are a kind of debt instrument where the interest is a function of the term of the security. They, therefore, differ from traditional bonds because their rate is fixed throughout all periods in their terms. On the other hand, the rate of an FRN is related to a benchmark index, similar to LIBOR, SOFR, and Treasury Bill Rates. These benchmarks are periodically changed, usually every three to six months. This ensures that the interest rates keep pace with the prevailing market conditions. Floating Rate Notes can be issued by governments, corporations, and other institutions seeking to raise funds.
This rate normally comprises two elements: the benchmark value and a fixed spread. In the process, this spread is usually meant to reimburse investors for credit risk related to the issuer. For instance, if the benchmark rate, say LIBOR, is 2 percent with a spread of 1 percent, the floating-rate note will attract an interest rate of 3 percent for that given period only. Although the diffusion of 1 percent will be constant, the benchmark rate of 2 percent will vary with time. This adjustment increases or decreases the interest rate so that it is more in line with the prevailing market rates.
FRNs offer a floating return rate along with the safety of a fixed spread, making it an attractive investment for those who are looking for balance. The interest rates thus change according to the market condition, but still maintain stability.
The only point of difference for FRNs compared with Plain Vanilla Bonds is the mechanism of computing their interest. Again, while this is a mode of borrowing by the issuer to the investor's mode of investing, it may appeal to very different preferences about the type of investment or about market conditions.
Interest Rate Structure
FRNs: The rate of interest floats and is set on the LIBOR or Treasury Bill rates and changes periodically. This feature has FRNs responsive to market movements in interest rates, which would be very appealing in a rising rate environment.
Plain Vanilla Bonds: The interest rate is constant over the lifetime of the bond. While predictability and stability are the hallmark, the value of such bonds decreases in the event of rising interest rates.
Market Behavior
FRNs: The interest rates are floating, which keeps them competitive in the market based on current interest rates. For example, when the market rates increase, the periodic adjustments keep FRNs competitive.
Plain Vanilla Bonds: The fixed interest payments make them vulnerable to changes in interest rates. If the market rates increase, the fixed returns of such bonds may seem less attractive, which can make their market value decline.
Suitability
FRNs Most appropriate for those investors who may anticipate interest rate rising or those requiring protection against any volatility in the interest rates.
Plain vanilla bonds appeal to risk-averse investors needing regular and predictable income in stable or declining interest-rate environments.
Both instruments carry merits and are applied for performing different roles within a diversified portfolio. Investors would consider their objectives, financial perspectives, and overall market outlook when having to choose one of the instruments.
Floating-Rate Notes are relatively unique and, therefore, have some relative advantages, but they also carry risks. Understanding these risks is important to help avoid poor decisions.
Credit Risk
Credit risk is the risk that the issuer will not meet his obligation, such as paying interest or returning the principal. In general, FRNs issued by the government have low credit risk because it is backed by sovereign guarantees; FRNs issued by corporations rely more on the creditworthiness of the issuer. Company financial health, industry performance, and market conditions can all have an impact on its ability to meet debt obligations. Investors should study credit ratings given by reputed agencies before investing in corporate FRNs.
Interest Rate Risk
Although FRNs are structured to counter interest rate risk by periodically resetting rates, they are not totally immune to the risk. The interest payments of FRNs could decline in a declining interest rate environment, thus making them less attractive than fixed-rate instruments locking in higher returns. Furthermore, the fixed spread over the benchmark might not fully compensate for inflation or drastic economic changes. With clients relying on periodic income, investment changes in yield may have adverse effects on their income and returns.
Pros and Cons of Floating-Rate Notes
Pros | Cons |
Payments adjust to reflect market rates, protecting against rising interest rates. | Interest payments decrease when benchmark rates decline, affecting income. |
Less sensitive to interest rate fluctuations compared to fixed-rate bonds. | Requires understanding of benchmarks and market dynamics, which can be daunting for beginners. |
Available from governments, corporations, and financial institutions, catering to various risk profiles. | Corporate FRNs carry the risk of issuer default, which depends on credit ratings and financial stability. |
Many FRNs are traded in secondary markets, allowing investors to exit before maturity. | Declining benchmark rates can reduce the returns on reinvested payments. |
Regular rate adjustments help FRNs keep pace with inflation over time. | Fixed-rate bonds may offer better returns during stable or declining interest rate periods. |
Flexible maturities make them suitable for various investment horizons. | Rate variability may not suit investors relying on stable cash flows. |
In 2014, for the first time in nearly two decades, it brought to the forefront a novel type of Treasury security by unveiling Floating-Rate Notes. This move was a response to growing demand for variable rate securities that deliver a safe investment vehicle with a measure of flexibility. Principal Features of US Treasury FRNs: Benchmark: It is pegged to the rate of the 13-week Treasury Bill.
Safety: Offered by the United States government with virtually no credit risk
Floating Rates: Re-pricing quarterly based on current market levels.
Maturity: Two-year term, satisfying the short-term investment horizon
Liquidity: Actively traded in secondary markets, with ease of entry and exit.
This product demonstrated how FRNs could be safe and flexible at one and the same time, and so qualify to enter both conservative as well as growth-oriented investors' portfolios.
FRNs are floating-rate notes, which have the advantage of adjusting to the market conditions and, therefore, are more appealing during periods of rising interest rates. Their regular income with preservation of market value makes them more attractive in volatile environments, but investors need to weigh their risks, including credit and interest rate fluctuations, before adding them to their portfolio.
Only when one understands the nuances of structure, risks, and the benefits of Floating Rate Notes will he be able to decide whether this tool is right for his financial goals. A financial advisor can also help in creating an investment plan that involves FRNs.
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Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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Share this article: 
The interest rate on an FRN changes periodically by adding a fixed spread to the benchmark rate, which could be the LIBOR or Treasury Bill, thus making it a rate in sync with the current market.
FRNs offer protection against rising interest rates, liquidity at secondary markets, and periodic income generation. They are also inflation hedges.
Yes, FRNs perform best in a rising rate environment because periodic adjustments ensure that the interest payment increases and hence better returns.
FRNs are of variable rates and periodically reset according to some benchmark, while fixed-rate bonds have stable and constant interest payments during their lifetime.
Yes, FRNs can be issued by governments, financial institutions, and corporations, providing different choices for investors with different levels of risk acceptance.
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