Floating Rate Note (FRN)

A floating rate note is a bond or note whose coupon is recalculated at set intervals as a reference rate plus a fixed margin, rather than being set once at issue. The US Treasury's floating rate note is the instance with a published rulebook. TreasuryDirect describes FRNs as short-term investments that "mature in two years," "pay interest four times each year," and "have an interest rate that may change or 'float' over time," and the Treasury's auction regulation at 31 CFR 356.5(b)(3) specifies the mechanics: Treasury floating rate notes "are issued with a stated spread to be added to the index rate for daily interest accrual throughout each interest payment period," have "a zero-percent minimum daily interest accrual rate," have "interest payable quarterly," are "redeemed at their par amount at maturity," and have maturities of at least one year but not more than ten.

Treasury classifies the FRN as a kind of note. The same regulation uses the label "non-indexed" for ordinary fixed-coupon notes and bonds precisely "to distinguish such notes and bonds from 'inflation-protected securities' and 'floating rate notes,'" so a Treasury FRN sits alongside the fixed-rate note and the inflation-protected note as a third design, each answering a different question about what the holder wants protected: the fixed-rate note protects the payment, the inflation-protected note protects purchasing power, and the floating rate note protects the price.

The rate: an index that moves and a spread that does not. TreasuryDirect states that "the interest rate of an FRN is the sum of two components: an index rate and a spread." The regulation defines the index for floating rate notes as "the highest accepted discount rate on 13-week bills determined by Treasury auctions of those securities," and the index rate as the simple-interest money market yield, computed on an actual/360 basis and rounded to nine decimal places, derived from that discount rate. Treasury auctions the 13-week bill every week, so, in TreasuryDirect's words, "the index rate of an FRN is reset every week," taking effect the day after each bill auction. The spread is "the fixed amount over the life of a floating rate note that is added to the index rate," expressed in tenths of a basis point and set once, at the auction that first sells the note: it equals the high discount margin accepted in that auction. Section 356.20(c) puts the two together: the interest rate "will be the spread plus the index rate ... subject to a minimum daily interest accrual rate of zero percent." Interest accrues on the par value every day at that day's rate and is paid every three months.

Why the price sits near par and the income does not. A fixed-coupon note promises the same dollars every six months for years; when market rates rise above its coupon, the only way for a buyer to earn the market rate is to pay less for the note, so its price falls. A floating rate note's coupon rises with the market instead, so there is no stale promise for the price to adjust around, and the note trades close to par throughout its life. The interest rate risk has not disappeared; it has moved from the price to the income. A holder who needs a predictable payment has taken on uncertainty, and a holder who wants the principal to hold its value in a rising-rate market has found the security designed for that. The zero floor means the daily accrual rate cannot go negative even if the spread is negative and bill rates fall to zero; it does not mean the coupon is guaranteed to be positive in any meaningful amount.

How an FRN is bought at auction. Bidders in a floating rate note auction do not bid a yield; they bid a discount margin, "the margin over the index that equates the present values of the assumed cash flows on a floating rate note to the sum of the price of and accrued interest on the floating rate note." Competitive bids state the discount margin as a percentage with three decimals and may be positive, negative or zero. In a new-issue auction the high accepted discount margin becomes the note's spread for life and the price is at or near par; in a reopening the spread is already fixed, so a discount margin bid above or below it produces a price below or above par. Noncompetitive bidders, which is how individuals buy through TreasuryDirect, simply accept the result. The Treasury FRN is issued in $100 minimums and increments, with new issues in January, April, July and October and reopenings in every other month, and it is not eligible for STRIPS. Interest is subject to federal income tax in the year earned and exempt from state and local income tax, like other Treasury securities.

Floating rate notes outside the Treasury. Corporations, banks and government-sponsored enterprises issue floating rate notes on the same template: a reference rate that resets periodically plus a spread fixed at issue, with the payment frequency, reset dates and any caps or floors set out in the note's own terms. For decades the reference rate for US dollar floaters was LIBOR; it is now generally the Secured Overnight Financing Rate, which the New York Fed describes as "a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities," and the statutory transition that replaced LIBOR in legacy contracts is covered on the SOFR page. Two things separate a corporate floater from the Treasury version. The spread is larger and reflects the issuer's credit, so a floater from a weak issuer can fall in price for reasons that have nothing to do with rates. And the reset is on the note's schedule rather than weekly, so between resets a corporate floater's price can drift from par as short-term rates move. Neither of those features has a Treasury analogue, and a reader comparing a Treasury FRN's spread with a bank floater's is comparing a term-premium with a credit spread.

At the original auction, Treasury sells the note and the high accepted discount margin becomes its spread. Every week thereafter, the 13-week bill auction produces a new high discount rate, Treasury converts it to an index rate, and from the next day the note accrues interest daily at the index rate plus the spread, never below zero. Every three months the accrued interest is paid; after two years the par amount is repaid. A holder who sells before maturity receives a market price that, because the coupon tracks the market, is usually close to par.

A hypothetical example. Sam holds $10,000 of a Treasury FRN whose spread was set at 0.150 percent at its original auction. This week's index rate, derived from the 13-week bill auction, is 4.250 percent, so the note accrues interest at 4.400 percent a year (4.250 plus 0.150). If that rate held for a full quarter, the quarterly payment would be about $110 ($10,000 times 4.400 percent, divided by 4). Suppose bill rates then fall and the index rate resets to 3.750 percent; the note's rate becomes 3.900 percent and a full quarter at that rate would pay about $97.50 ($10,000 times 3.900 percent, divided by 4). Because each week's accrual uses that week's rate, the actual quarterly payment is a blend of the thirteen weekly rates in the period.

The contrast with a fixed-rate note is the point. Had Sam instead bought $10,000 of a two-year Treasury note with a fixed 4.400 percent coupon, the fall in short-term rates would have left his coupon at 4.400 percent and pushed his note's market price above par; had rates risen instead, his income would have stayed fixed and his note's price would have fallen. The FRN's price barely moves in either case, and its income does all the adjusting.

Pros

• The price stays close to par because the coupon resets to the market, so a holder who may need to sell before maturity is exposed to far less price risk than in a fixed-coupon note of the same term.
• Income rises automatically when short-term rates rise, with no need to sell and reinvest.
• The Treasury version carries the same full-faith-and-credit backing and state and local income tax exemption as other Treasury securities, in $100 increments through TreasuryDirect.
• The daily accrual rate has a floor of zero, so the coupon cannot turn negative.

Cons

• Income is unpredictable; a holder who needs a known payment has bought the wrong instrument, and when short-term rates fall the coupon falls with them.
• The Treasury FRN is a two-year security only, so it offers no way to lock in a rate for longer, and it is not eligible for STRIPS.
• A corporate or bank floating rate note adds credit risk and a reset schedule that lets its price drift from par between resets, so "floating rate" alone does not mean "safe."
• The spread is fixed for life at the original auction, so a note issued when spreads were tight keeps that spread even if the market later demands more.