Floating Rate Notes

Floating rate notes, or FRNs, are variable-rate securities that have periodic interest adjustments. Typically, these securities are redeemable at face value at certain times, and pay the current prevailing interest rate of a money market index plus a spread, or constant margin of profit. In the U.S., the Federal funds rate is a commonly used index, while the Europe Interbank Offered Rate or LIBOR is more typically used in Europe and elsewhere in the world.

Floating rate note issuance

Floating rate notes are most often issued by government agencies in the U.S. and backed by government-insured mortgages or loans. In Europe, floating rate note issuance is generally the purview of major banks and financial institutions. Because of the stable nature of the issuing agencies or institutions, floating rate notes are considered a relatively safe investment choice. There are a number of different types of floating rate notes available on the market:
  • Capped FRN securities have a maximum coupon rate to limit risk to the seller.
  • Floored FRN securities have a minimum coupon rate to ensure a certain level of return on investment to the buyer.
  • Collared FRNs incorporate both a minimum and maximum coupon rate to limit return and risk to a specific range of interest rates.
  • Perpetual FRN securities offer a specific interest stream, but have no set maturity date and are treated as capital investments in most cases.

Floating rate note duration

Because floating rate notes are so closely tied to a specific index, their performance and coupon rate is typically evaluated every thirty to ninety days when interest rates are reset. However, because FRNs often trade near or at par and remain there throughout the entire term of the note, their volatility is directly tied to the overall market performance; thus, most analysts assess the true duration of an FRN at near zero.

Floating rate notes in exchange-traded funds

Floating rate notes are an attractive addition to most exchange-traded funds, or ETFs, due to their minimal level of risk and generally solid performance in most economic conditions. Floating rate notes ETF investments, like other FRN investments, typically are backed by bank loans or mortgages and in most economic conditions provide a larger measure of risk security than other types of investments because the debt is secured by underlying assets.
Tim Ord
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