Variable Interest Rates

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A floating-rate note, also known as an FRN or a "floater," is a debt instrument with an interest rate that varies based on a certain benchmark. Common floating-rate note benchmarks include LIBOR, the federal funds rate, and the U.S. Treasury bill rate. Most of them have a two- to five-year maturity.

How floating-rate notes work

Floating-rate notes are issued by both government entities and private corporations, and their interest rates change at specified intervals based on a certain benchmark. Floating-rate notes typically have maturities ranging from two to five years, though longer or shorter maturities aren't unheard of. Interest rates can reset at a variety of frequencies ranging from daily to annually, though monthly and quarterly intervals are the most common.

For example, a floating-rate note might be issued with a maturity of two years and an interest rate that resets quarterly based on the three-month LIBOR rate plus 0.2%. As of this writing, the three-month LIBOR rate is 0.66%, which means the note would pay 0.86% for its first quarter after its issuance. If the three-month LIBOR were to rise to 1% after one quarter has passed, then the note's interest rate would reset to 1.2%.

This is in contrast to a fixed-rate note, which pays the same interest rate for its entire maturity. Because floating-rate notes are based on short-term interest rates, which are generally lower than long-term rates, a floating-rate note typically pays lower interest than a fixed-rate note of the same maturity.

Just like fixed-rate notes, floating-rate notes can be callable or non-callable, which means that the issuer may have the option to repay the principal before the maturity date is reached. Floating-rate notes may also have what's known as a "cap" or "floor." A cap is a maximum interest rate the note can pay, regardless of how high the benchmark rate climbs, and a floor is the lowest allowable payment.

Benefits to investors

In a nutshell, the reason investors would prefer floating-rate notes is to minimize their interest rate risk. Let's say you have the choice between two securities -- a two-year Treasury note with a 0.7% interest rate, or a two-year floating-rate Treasury note that currently pays 0.5% but is based on the 13-week Treasury bill rate plus 0.2%.

If interest rates spike later this year, the fixed-rate Treasury note will still be paying 0.7%. However, if the 13-week Treasury rate rises to 1%, then the floating-rate note would pay 1.2%.

In other words, investors may be willing to accept a lower initial rate in exchange for the possibility of a higher rate if market rates rise. This is a particularly appealing benefit in today's low-interest environment, as investors may not want to lock in a low interest rate.

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