Image Source: Getty Images.
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.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at [email protected]. Thanks -- and Fool on!
