Floating Rate Notes Advantages and Disadvantages

We have previously discussed fixed-income instruments such as fixed-rate bonds, callable putable bonds. In this article, we are going to look into floating-rate notes.

What is a Floating Rate Note?

A floating-rate note (FRN) is a debt instrument that comes with a floating or variable interest rate. The interest rate on floating-rate notes come from a benchmark rate, usually taken as the US Treasury note or Federal Reserve funds rate. Therefore, the coupon rates on these debt instruments are variable. Usually, floating-rate notes offer a benchmark rate plus a fixed spread.

For floating-rate notes, the coupon rate gets adjusted after regular intervals of time. These may occur monthly or quarterly depending on the benchmark. Usually, floating-rate notes come with a maturity date of two to five years. Like other types of debt instruments, floating-rate notes may come from government and private sector entities.

How do Floating Rate Notes work?

Floating-rate notes are prevalent in the bond market. These are usually more preferable for investors who don’t want fixed rates on their debt instruments. Investors that buy floating-rate notes do so to benefit from the increasing market rates. Since these notes offer variable interest rates, investors don’t have much to lose as opposed to fixed-rate debts.

Floating-rate notes pay a lower return to investors compared to fixed-rate instruments. It is because these notes are benchmarked to short-term rates. However, these come with higher security. Investors get the benefit of rising interest rates when the benchmark rates rise. In these conditions, fixed-rate bonds will yield fixed returns. However, investors also face the risk of lower interest rates in case the benchmark rate falls.

What are Floating Rate Notes’ advantages and disadvantages?

Floating-rate notes have some advantages and disadvantages. These are as below.

Advantages

Floating-rate notes can be highly profitable when the market interest rates are rising. Investors stuck with fixed-rate instruments have to suffer lower interest rates. Since the interest rates on these floating-rate notes are tied to the benchmark rate, these investors will get higher returns.

Floating-rate notes also suffer less due to price volatility. Since the interest rate on these instruments changes with changes in benchmark rates, they do not suffer due to interest rate changes. Therefore, their prices remain steady over time.

Disadvantages

In some circumstances, floating-rate notes can be more disadvantageous than advantageous. Firstly, like any other debt instrument, floating-rate notes come with default risk. Therefore, investors may suffer if the issuer of these notes liquidates or defaults on repayments.

Similarly, when the interest rates in the market are falling, floating-rate note holders have to suffer. In these circumstances, they get lower interest payments while fixed-rate debt holders can benefit from their steady income.

As mentioned above, floating-rate notes also come with lower returns as compared to fixed-rate instruments. Therefore, investors have to choose between getting higher incomes or security when choosing these notes.

Conclusion

Floating-rate notes are debt instruments that come with variable interest rates. The interest rates on these notes come from a benchmark rate. Therefore, the interest payments that investors receive on fixed-rate notes vary according to the market rate. Due to their characteristics, these notes can have several advantages and disadvantages.

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