Floating Rate Notes: A Beginner’s Guide
If you’re looking for a safe investment that can offer attractive yields, floating rate notes (FRNs) might be worth considering. FRNs are bonds whose interest rates adjust periodically based on a benchmark rate such as the London Interbank Offered Rate (LIBOR). In this article, we’ll discuss what FRNs are, how they work, and why you should consider adding them to your portfolio.
What Are Floating Rate Notes?
A floating rate note is a type of bond with variable interest payments. Unlike fixed-rate bonds, which pay a fixed interest rate throughout their life span, FRNs feature an adjustable coupon that changes over time based on market rates. The issuer of the bond sets an initial margin above or below the reference index used to calculate the coupon payment.
For example, if the reference index is LIBOR (the average interest rate at which banks lend money to each other), an issuer may set its margin at 1%. If LIBOR were 2%, then investors would receive a coupon payment of 3% per annum. Conversely, if LIBOR dropped to 0%, investors would receive only 1%.
How Do Floating Rate Notes Work?
FRNs work by using a two-part formula:
Coupon = Reference Index + Margin
The reference index is usually tied to short-term interest rates in the country where the bond was issued. For US dollar-denominated bonds, it’s common for issuers to use LIBOR or another benchmark like the Federal Funds Rate as their reference index. The margin is added or subtracted from this base rate depending on various factors such as creditworthiness and duration of maturity.
When buying an FRN bond issue during its primary offering period or through secondary markets like stock exchanges and brokerages firms, investors typically receive periodic payments throughout its lifespan until maturity when they get back their principal sum invested.
Why Invest in Floating Rate Notes?
There are several reasons why investors might consider including FRNs in their portfolios. First, they offer an excellent way to protect against rising interest rates. As the reference index increases, so does the coupon payment on your bond—making it a good hedge against inflation.
Secondly, FRNs are suitable for income-seeking investors who want higher yields than traditional savings accounts or CDs but don’t want to take on too much risk. They’re typically issued by high-quality borrowers like government entities and large corporations with strong credit ratings, which means they have relatively low default risks.
Finally, floating rate notes can be advantageous in periods of economic uncertainty when fixed-rate bonds may not perform as well. Since the coupon payments adjust based on current market conditions rather than being locked in at a fixed rate from issuance, they can provide some protection against changes in interest rates.
Risks Associated with Floating Rate Notes:
Like any investment, there are risks associated with investing in FRNs that you should be aware of before taking the plunge. The main one is credit risk—the risk that the issuer won’t be able to make its payments due to financial difficulties or bankruptcy.
Another risk is liquidity risk which can arise from price volatility since trading volumes will often be lower compared to other investments such as stocks or ETFs due primarily because most issuers only issue small amounts of these bonds at any given time.
Lastly, there’s reinvestment risk—the possibility that you may have difficulty finding another investment offering similar returns once your bond matures and you receive back your initial principal amount invested plus final coupon payment(s).
Conclusion:
Floating-rate notes (FRNs) offer investors an opportunity to earn higher yields while protecting themselves against rising interest rates. They also tend to have low default risks since they’re usually issued by high-quality borrowers like governments and large corporations with strong credit ratings. However, like all investments, there are some risks involved that you must understand before making any decisions about whether or not to invest.