Fixed vs Floating Rate Notes: Coupon Risk Compared

Key Takeaways

• A fixed rate note locks the coupon at issue, so its price swings inversely with market rates; a floating rate note resets its coupon, so its price stays close to par.
• A floater's coupon equals a reference rate (today usually SOFR) plus a fixed spread, recalculated at each reset date.
• Fixed notes carry meaningful duration; floaters carry almost none, because the next reset is rarely more than a quarter away.
• Fixed notes protect your income and expose your price; floaters protect your price and expose your income.

What It Is

A fixed rate note is a bond whose coupon is set as a percentage of face value at issuance and never changes. A 5-year note with a 4% coupon on $1,000 face pays $40 every year regardless of what happens to market rates.

A floating rate note (FRN, or floater) pays a coupon that is reset on a schedule, typically quarterly. The coupon is defined as a reference rate plus a fixed spread (also called the margin or quoted margin). If the reference rate is 3.4% and the spread is 0.60%, the coupon for that period is 4.0%. When the reference rate rises, the next coupon rises with it.

The Intuition

Bond prices move opposite to yields because a fixed coupon becomes less attractive when new bonds pay more. A floater sidesteps this: instead of the price falling to make an old coupon competitive, the coupon itself is rewritten to match the market. Because the cash flow re-prices, the price barely has to.

So the risk does not disappear; it moves. With a fixed note you keep certain income but accept price risk. With a floater you keep a stable price but accept income that can fall when rates fall.

How It Works

The mechanics differ in three places:

• Coupon setting. Fixed: one rate for the life of the bond. Floating: reference rate plus spread, refreshed each reset date.
• Duration. Duration measures price sensitivity to rate moves. A fixed note's duration reflects its full maturity. A floater's duration is roughly the time to its next reset, usually about 0.25 years for a quarterly floater, because after that point the coupon adjusts on its own.
• Where risk lands. A fixed note pushes rate risk into price. A floater pushes it into the income stream, while its price hugs par.

The spread on a floater is fixed at issue and reflects credit risk, not rate risk. If the issuer's creditworthiness deteriorates after issuance, the floater's price can still fall even though its rate risk is small, because the fixed spread no longer compensates for the higher credit risk.

Worked Example

Compare two $1,000 face, 5-year notes issued when the reference rate is 3.4%.

• Fixed note: 4.0% coupon, so $40 per year, priced at par ($1,000) at a 4% yield.
• Floating note: coupon = reference rate + 0.60% spread. At issue that is 3.4% + 0.60% = 4.0%, also $40 for the first period, also priced at par.

Now suppose market rates rise by 1.00% (100 basis points).

The fixed note's price falls. Its modified duration is about 4.45 years, so the price change is roughly -4.45% x 1.00% = -4.45%, taking the price to about $956. The coupon stays $40.

The floating note barely moves. Its duration is about 0.25 years, so the price change is roughly -0.25% x 1.00% = -0.25%, to about $997.50, and it snaps back toward par at the next reset. At that reset the reference rate is now 4.4%, so the new coupon is 4.4% + 0.60% = 5.0%, or $50 per year.

Result: the fixed holder lost about $44 of price and kept a $40 coupon; the floating holder kept the price and saw income rise to $50. If rates had fallen 1% instead, the fixed holder would have gained price while the floater's coupon dropped toward $30.

Common Mistakes

1. Assuming floaters are risk-free. A floater neutralizes most rate risk, not credit risk. A weakening issuer can still see its floater trade below par.
2. Ignoring the spread. Two floaters on the same reference rate are not equivalent; the spread reflects credit quality and drives most of the yield difference.
3. Forgetting the reset lag. Between resets a floater does carry a little duration, so a sharp rate move mid-quarter still nudges the price.
4. Believing floaters always beat fixed. Floaters win when rates rise; when rates fall, the fixed coupon keeps paying while the floater's income shrinks.
5. Overlooking caps and floors. Some floaters cap the maximum coupon or floor the minimum, which changes the payoff when the reference rate moves to an extreme.

Frequently Asked Questions

Q: What is the core difference in fixed vs floating rate notes? A fixed note pays the same coupon for life, so its price moves inversely with rates. A floating rate note resets its coupon to a reference rate plus a spread, so its price stays near par while its income moves with rates.

Q: Which is better in a rising-rate environment, fixed or floating? Floating usually. In the fixed vs floating rate notes comparison, a floater's coupon steps up as the reference rate rises and its price holds near par, whereas a fixed note's price falls while its coupon is stuck.

Q: What reference rate do floating rate notes use? Most new dollar floaters use SOFR (the Secured Overnight Financing Rate), which replaced LIBOR. The coupon is that reference rate plus a fixed spread set at issuance.

Q: Do floating rate notes have duration? Very little. A floater's duration is roughly the time to its next reset, often about a quarter, so its price is far less sensitive to rate moves than a comparable fixed note.

Q: How does credit risk appear in fixed vs floating rate notes? In both, the spread and price reflect issuer credit. In fixed vs floating rate notes, a floater strips out most rate risk but leaves credit risk in the fixed spread, so a downgrade can still push the price below par.

Sources

1. Investopedia. "Floating Rate Note (FRN)." https://www.investopedia.com/terms/f/frn.asp
2. Investopedia. "Fixed-Rate Bond." https://www.investopedia.com/terms/f/fixed-rate-bond.asp
3. TreasuryDirect. "Treasury Floating Rate Notes." https://www.treasurydirect.gov/marketable-securities/floating-rate-notes/
4. Federal Reserve Bank of New York. "Secured Overnight Financing Rate (SOFR)." https://www.newyorkfed.org/markets/reference-rates/sofr

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.