Floating rate notes: Overview, definition, and example
What are floating rate notes?
Floating rate notes (FRNs) are debt securities that have an interest rate which is periodically adjusted based on a reference rate, such as LIBOR (London Interbank Offered Rate) or SOFR (Secured Overnight Financing Rate). Unlike fixed-rate bonds, where the interest rate remains constant throughout the life of the bond, the interest rate on floating rate notes changes at regular intervals, typically every 3, 6, or 12 months, in line with fluctuations in the reference rate.
This adjustment allows the issuer and investors to manage interest rate risk, as the coupon payments will vary with market conditions. Floating rate notes are often issued by governments, corporations, and other entities to raise capital while offering more flexibility in the interest rate compared to fixed-rate bonds.
Why are floating rate notes important?
Floating rate notes are important because they provide a way for both issuers and investors to manage interest rate risk. For investors, the ability to adjust the interest rate periodically can protect them from rising interest rates, ensuring they receive competitive returns. For issuers, FRNs can be an attractive way to borrow money, especially when market interest rates are expected to rise, as the variable rate allows them to adjust their debt servicing costs accordingly.
These notes are particularly useful in times of economic uncertainty or when interest rates are expected to increase, as they offer more flexibility compared to fixed-rate debt instruments.
Understanding floating rate notes through an example
Imagine a company, ABC Corp., issues floating rate notes with a 6-month reset period, tied to LIBOR. If LIBOR is 1% at the time the note is issued, the interest rate on the note would be set at LIBOR + 2%. So, in the initial period, the coupon rate would be 3% (1% + 2%). Six months later, if LIBOR rises to 1.5%, the coupon rate would increase to 3.5% (1.5% + 2%).
This means that the interest payments made by ABC Corp. to bondholders will increase in response to the rise in LIBOR, protecting bondholders from inflation or rising interest rates in the market.
Another example could involve a government issuing FRNs that are tied to SOFR. If the SOFR rate is 0.5% at issuance, and the note is set at SOFR + 1%, the bondholder would receive a 1.5% coupon initially. As SOFR fluctuates, so would the interest payments.
An example of a floating rate note clause
Here’s how a clause related to floating rate notes might appear in a bond agreement:
“The interest rate on the Floating Rate Notes will be determined by adding [X]% to the reference rate, which shall be the LIBOR rate for a 3-month period, with the rate being adjusted every three months based on the then-current LIBOR rate.”
Conclusion
Floating rate notes are a type of debt instrument where the interest rate fluctuates with market conditions, typically tied to a reference rate like LIBOR or SOFR. They are important tools for both issuers and investors to manage interest rate risk, offering flexibility and protection in changing market conditions. By providing regular adjustments to the interest rate, FRNs help ensure that debt servicing costs remain aligned with prevailing interest rates, making them an appealing choice for issuers and a more attractive investment for those seeking to hedge against rising rates.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.