Bonds are often the investment of choice for people seeking stability. They don’t yield much, unless you have sought out the junk market, but they come with highly stable returns. Bonds can be seen as the dad jokes of investing: boring, predictable and there when you need them.
However, sometimes you can spice up your bonds just a little. That’s where floating rates come in. Here’s a breakdown of floating rate notes and what you need to know before you invest.
A financial advisor can help you create a financial plan for your investment needs and goals.
What Is a Floating Rate Note?
A floating rate note (FRN) is a bond or other debt instrument with an interest rate that changes based on some external benchmark. (For this article, we’ll keep it simple and refer to bonds going forward. However a floating rate note can technically refer to any interest bearing debt instrument.)
Typically a floating rate note will be based on one of three benchmarks: The U.S. Federal Funds Rate (otherwise known as the Federal Reserve interest rate or sometimes just “the Fed”), the U.S. Treasury bill rate and the London Interbank Offered Rate (LIBOR).
Each floating rate note has what’s called a “reset period.” This is how often the note updates its interest rate based on the external benchmark. Reset periods vary widely. Some notes may reset their interest rates daily or weekly, while others may do so only quarterly or annually.
Floating rate notes typically have relatively short maturity periods compared to a traditional bond. A common FRN will mature in between two and five years, although this is not universal.
Finally, a floating rate note may have what’s called a “cap” and a “floor.” These are the upper and lower bounds that the bond can return. A floating rate note may not pay more than its cap or less than its floor.
Example of a Floating Rate Note
A bank might issue the following floating rate note:
- Principal: $1,000
- Interest Rate: Federal Funds Rate +0.25
- Reset Period: Three months
- Maturity: Five years
This note would have a face value of $1,000. In five years the note will mature and will repay that principal. During that five years the note will have an interest rate set at the Federal Reserve’s interest rate plus 0.25. For example, if the Federal Reserve rate was 2.5%, this note would bear an interest of 2.75%.
Every three months, timed to the quarterly Federal Reserve meeting, the note will update its interest rate. If the Federal Reserve rate has changed, this note will update its interest rate to match. For example, say at the board’s next meeting the Federal Reserve rate falls to 2%. This floating rate note, at its next reset date, would take on an interest rate of 2.25%.
Floating Rate Notes vs. Fixed Rate Notes
The alternative to a floating rate note is what’s called a “fixed rate note.” This is a traditional bond.
Fixed rate notes have an interest rate assigned at the time you buy them. This does not change during the lifetime of the instrument. For example, if you purchase a fixed rate note with an interest rate of 2%, it will pay 2% of its principal in interest until the date of maturity.
Like floating rate notes, fixed rate notes repay the full principal upon maturity.
Fixed rate notes tend to have longer maturities than floating rate notes. This is particularly true of government bonds, many of which take decades to mature. Partially because of this, they also tend to have higher interest rates. Floating rate notes, being a more short-term instrument, typically set their interest rates around short-term benchmarks. This tends to result in a lower rate of return.
Finally, due to their potentially volatile interest rates, floating rate notes have unpredictable coupon payments (by amount, not by date; the date of a floating rate note’s coupon payment remains fixed). This is as opposed to fixed rate notes, in which coupon payments do not change.
Value of a Floating Rate Note
A floating rate note allows investors a certain degree of speculation in an otherwise stable instrument.
Most bonds, particularly long-term ones, tend to pay a fairly low rate of return. More importantly they pay a guaranteed rate of return. This keeps the investor’s money safe even through market turmoil. Yet this also means that the investor can’t take advantage of strong market conditions.
Say, for example, you have two potential bonds. The first is a fixed rate note paying 3%. The second is a floating rate note set to the Federal Reserve Rate plus 0.25. Under current market conditions, you would be wise to take the fixed rate note. It pays a higher rate of return than the floating rate note.
However, suppose the Federal Reserve raised rates to 3%. In this case your fixed rate note would become a lost opportunity because its rate of return would not improve with the market. Your floating rate note, on the other hand, would.
Of course the opposite holds true. If the Federal Reserve were to cut rates, your floating rate note would fall even farther behind the fixed rate instrument.
For institutional investors, this can also help to offset some areas of risk. Raising interest rates often can slow down an economy, dragging down the value of many investments. A floating rate note that issues higher rates of return with rising interest rates can defray some of those losses, creating a counter-cyclical instrument that has higher returns while the market at large might struggle.
Floating Rate Note: Pros and Cons
A floating rate note has several variables to consider before investing. The advantages include:
- A potentially higher rate of return compared with fixed rate notes if benchmark rates rise during the lifetime of the instrument
- Short-term maturity rates that will return your principal relatively quickly
- Confidence of repayment if you are dealing with a reputable institution
The disadvantages, however, include:
- A potentially lower rate of return compared with fixed rate notes if benchmark rates fall during the lifetime of the instrument
- Generally lower rates of return given the short-term nature of the instrument
- The potential for non-payment, most specifically when dealing with private institutions
How to Invest in Floating Rate Notes
A good place to start is with the U.S. Treasury. The government began issuing floating rate notes in 2014. These bonds have two-year maturity dates, are issued in minimum units of $100 and are benchmarked to 13-week Treasury bills.
Otherwise, you can contact an investment broker. Oftentimes, the best way to invest in non-government floating rate notes is as part of a mutual fund or ETF. These products bundle together multiple floating rate notes into larger, collectively benchmarked funds that you can buy into. This is particularly useful for a retail investor, as non-government floating rate notes are often issued by smaller institutions. This makes them more difficult to seek out individually and potentially more volatile or prone to default.
Bottom Line
Floating rate bonds are an option for investors, and may be ideal when interest rates are low and expected to rise. While it may be more difficult to purchase a floating rate note individually, investors can invest in a FRN through a mutual fund or ETF. Be mindful of investing in floating rate notes when interest rates are expected to fall. And if you’re sure of the right investment strategy for your financial goals, you can always work with an advisor.
Tips for Investors
- If you’re interested in investing in floating rate notes, consider working with a financial advisor to make sure it’s the right move for your money. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Before investing in a floating rate note such as a bond, consider every type of bond available. From zero-coupon bonds to callable bonds, there are many for investors to explore.
Photo credit: ©iStock.com/AndreyPopov, ©iStock.com/Sarawutnam, ©iStock.com/Yozayo