Floating Rate Note

Definition

Floating Rate Notes (FRNs) are debt instruments with variable interest rates that are tied to a benchmark rate, such as the U.S. Treasury rate, Federal Funds Rate, London Interbank Offered Rate (LIBOR), or the prime lending rate. FRNs are typically issued by financial institutions, governments, and corporations with maturities ranging from 2 to 5 years.

Origin

The concept of Floating Rate Notes originated in the 1970s when financial markets became more sensitive to interest rate fluctuations. Both investors and issuers sought to hedge interest rate risks through variable rates. As global financial markets evolved, FRNs became an important financing tool.

Categories and Features

FRNs can be categorized based on the issuer: government FRNs, financial institution FRNs, and corporate FRNs. Government FRNs are generally considered lower-risk investment options, while corporate FRNs may offer higher yields to compensate for higher risk. The main feature of FRNs is their periodically adjusted interest rates, typically every three or six months, based on changes in the benchmark rate, making them attractive in rising interest rate environments.

Case Studies

A typical example is the U.S. Treasury's issuance of floating rate bonds, where the interest rate is linked to the yield of 13-week Treasury bills, allowing investors to earn higher returns when interest rates rise. Another example is a major bank issuing FRNs tied to LIBOR, helping the bank maintain stable financing costs in a volatile interest rate market.

Common Issues

Investors in FRNs may face issues such as the choice of interest rate benchmark and market liquidity risk. A common misconception is that FRNs are safe investments in any market environment, but in reality, the choice of benchmark rate and changing market conditions can affect their returns and risks.