Floating-Rate Notes (FRNs)
What if a bond's interest weren't fixed and changed each time? Let's look at the principle of floating-rate notes (FRNs)—bonds whose interest rises along with rates when rates go up.
What is an FRN
A floating-rate note (FRN) is a bond whose interest (coupon) isn't fixed but changes periodically according to market rates.
Most bonds have fixed interest, like '5% a year.' An FRN, by contrast, sets its interest in the form of 'reference rate + a fixed spread,' and at set intervals (e.g., every three months) it re-reflects the reference rate to reset the interest.
For example, under a 'reference rate + 0.50% (50bp)' term, when the reference rate rises the next interest payment rises along with it.
Source: Ryan O'Connell CFA (Floating-Rate Bonds), CapMint. An FRN's coupon periodically resets by adding a fixed spread to a short-term reference rate.
The reference rate: from LIBOR to SOFR
The 'reference rate' that sets an FRN's interest has changed over time.
In the past, LIBOR (the London interbank rate) was widely used worldwide. But as trust wavered amid rigging scandals and more, U.S. dollar LIBOR was mostly discontinued after the end of June 2023.
Now it has transitioned to new reference rates including SOFR (Secured Overnight Financing Rate). Because LIBOR reflected bank credit risk and was slightly higher than SOFR, a spread adjustment was applied to bridge that gap during the transition. For example, the three-month adjustment was fixed at about 0.26% (26.161bp).
Source: ISDA Fallbacks FAQ, JPMorgan IBOR Reform FAQ. The three-month LIBOR-SOFR spread adjustment was confirmed at 26.161bp.
Why it's strong in a rising-rate environment
An FRN's biggest feature is that its interest rises along with rates when rates go up.
An ordinary fixed-rate bond can lose value as its price falls when rates rise. An FRN, by contrast, has its interest rise to follow the new rate, so its price tends not to swing much. That's why it's often mentioned as a relatively attractive defensive tool in a rising-rate environment.
But it's not a cure-all. In periods when rates fall, conversely, the interest you receive also shrinks. Also, the credit risk that the issuer may fail to repay, and the risk that spreads widen, remain exactly as with fixed-rate bonds.
An FRN only reduces rate risk; it doesn't eliminate credit risk. In a falling-rate period, interest income shrinks.
常见问题
Q. Do FRNs avoid losses even when rates rise?
It's true that their price moves less than fixed-rate bonds. Because the interest follows rising rates, the bond's price doesn't fall much. But that doesn't mean 'no losses at all.' If the issuer's credit worsens or spreads widen, the price can fall, and if rates fall, the interest you receive also shrinks.
Q. LIBOR is gone, so what happens to old FRNs?
U.S. dollar LIBOR was mostly discontinued at the end of June 2023, and fallback provisions were prepared so that existing contracts move to alternative reference rates like SOFR. At that point, a maturity-specific spread adjustment (about 0.26% for three months) was added to bridge the difference in nature between LIBOR and SOFR.
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