What are they?
Corporate floating rate notes (or FRNs) are investment-grade bonds issued by corporations that have a variable interest rate. First, let’s talk about bond coupons. A bond coupon is the annual interest from a bond. The bondholder receives their coupon payment from the time the bond is issued until it matures.
The coupon rate for FRNs is tied to a benchmark like the U.S. Treasury bill rate, the Fed funds rate, the prime rate or LIBOR. This means an FRN’s coupons adjust with changes in short-term rates. So, FRNs are often used to help reduce interest rate risk during periods of rising rates. FRNs typically have two- to five-year maturities.
1. Floating rates
Floating rates allow investors to earn the prevailing market interest rate plus a fixed spread while reducing the risks associated with rising rates. Corporate FRN coupons are adjusted on periodic reset dates determined by the issuer. The new coupon is calculated by adding a fixed spread — determined at issuance based on the issuer’s credit risk — to the current reference rate (for example, LIBOR). The fixed spread remains constant over the life of the note. Typically, the wider the spread, the riskier the FRN. Most investment-grade corporate FRNs make coupon payments quarterly, allowing investors to benefit from rising rates relatively quickly.
2. Stable prices
Traditional fixed-rate bond prices are inversely related to interest rate movements — when interest rates rise, bond prices fall, and vice versa. The amount the bond’s price falls depends on its duration. A duration is a measure of the bond’s sensitivity to changing interest rates. Because an FRN’s coupon adjusts with short-term interest rates, it tends to have a duration close to zero. Although FRNs aren‘t completely hedged against interest rate risk, their prices remain relatively stable over time compared to fixed-rate bonds.
3. Investment-grade credit ratings
Most corporate floating rate notes carry an investment-grade credit rating, meaning credit agencies consider these issuers less likely to default on their payments. This feature makes them different from bank loans, which are floating rate notes that are often considered “speculative” or “junk” due to the meaningful credit risk they carry.
4. Caps and floors
Many FRNs are issued with a cap, a floor or both. A cap determines the maximum interest rate an issuer will pay despite the level interest rates rise. Conversely, a floor guarantees that the issuer will pay a minimum interest rate, even if the coupon payment calculated by the reference rate is lower. Caps and floors aim to limit an investor’s upside and downside potential.
What are the advantages?
One of the primary advantages of corporate FRNs versus fixed-rate bonds is that investors may benefit from higher income payments as interest rates rise instead of locking in the current fixed rate for the long-term.
FRNs can help reduce a portfolio’s weighted-average duration due to their relative price stability, making an investor’s overall bond portfolio less sensitive to rising rates.
Corporate FRNs provide an opportunity for investors to add variable rate credit exposure to their portfolios without taking on excess credit risk.
FRNs can be traded in the secondary market, giving investors the flexibility to buy and sell when most appropriate. Investors can keep in mind the expected market environment and their financial plan before they make their move.
What are the risks?
Although most corporate FRNs are considered investment-grade, they do bear credit risk. It’s important to fully understand the creditworthiness of the issuer before investing.
FRNs aren’t completely hedged against interest rate risk. Additionally, their coupons are adjusted downward if interest rates fall, making them less attractive than comparable fixed-rate bonds.
Variable rates make it difficult for investors to predict their future income stream. The caps and floors on many FRNs help set a band around expected future payments.
Some FRNs are issued with a call option. If a callable floating rate note is called by the issuer prior to maturity, the investor may not be able to invest in a new FRN with the same or similar terms.
Who should purchase FRNs?
Typically, the best time to invest in FRNs is when short-term interest rates are relatively low and expected to rise. In a rising rate environment, their variable rate feature makes them ideal for investors focused on capital preservation and keeping pace with inflation. FRNs may also be appropriate for shorter-term cash management solutions.