Floating-Rate Notes: Coupons That Reset

Key Takeaways

• A floating-rate note has a coupon of "reference rate + spread," where the reference rate moves with the market and the spread stays constant for the life of the note.
• On each reset date the coupon is re-fixed to the current reference rate, so the note pays more when rates rise and less when they fall.
• Because the coupon adjusts, an FRN's price barely moves when rates change; its interest-rate duration is near the length of one reset period, not the full maturity.
• FRNs shift interest-rate risk onto the investor's income and away from the note's price, leaving credit spread risk as the main remaining exposure.

What It Is

A floating-rate note (FRN) is a debt security whose coupon is redefined periodically rather than fixed at issue. The coupon has two parts: a reference rate that resets to a published market benchmark, and a spread (also called the quoted margin) that is a fixed number of basis points added on top. A typical quote reads "SOFR + 40 bps." The reference rate floats; the spread does not.

Issuers include the US Treasury, government agencies, banks, and corporations. Maturities are usually short to intermediate, and resets are commonly monthly or quarterly.

The Intuition

A conventional fixed-coupon bond locks in one rate for years. If market rates then climb, that fixed coupon looks stingy, so the bond's price must fall until its yield matches the new environment. The investor holds a below-market coupon.

An FRN sidesteps that problem. Because the coupon resets toward current rates, the note rarely needs a price discount to stay competitive. The investor gives up the certainty of a fixed income stream and in return keeps a price that stays close to par. The trade is simple: fixed-rate bonds fix your income and float your price; a floating-rate note floats your income and fixes your price.

How It Works

Three mechanics define the note:

• Reference rate. The floating benchmark, such as SOFR or a Treasury bill rate. It is observed at or just before each reset.
• Spread. A fixed add-on that compensates for the issuer's credit risk and stays the same for the note's life.
• Reset. On a set schedule the coupon is recalculated as reference rate + spread and applied to the next period.

Between resets the coupon is fixed, so the note behaves like a very short bond until the next reset locks in the new rate. That is why an FRN's price sensitivity to interest rates, its duration, is roughly the time to the next reset rather than the years to maturity. What price risk remains comes mostly from changes in the issuer's credit spread: if the market decides the fixed spread no longer compensates for the issuer's risk, the price adjusts even though the reference rate keeps floating.

Worked Example

Consider a 3-year FRN with a $1,000 face value, a coupon of SOFR + 0.40%, and quarterly resets.

At the first reset, SOFR is fixed at 5.00%. The coupon rate for that quarter is 5.00% + 0.40% = 5.40% annualized. The quarterly payment is:

$1,000 × 5.40% ÷ 4 = $13.50

Three months later, at the next reset, SOFR has fallen to 4.50%. The new coupon rate is 4.50% + 0.40% = 4.90%, and the next payment is:

$1,000 × 4.90% ÷ 4 = $12.25

The spread held at 0.40% the whole time; only the reference rate moved, dragging the coupon down $1.25 for the quarter. If SOFR had instead risen to 5.75%, the coupon rate would be 6.15% and the payment $1,000 × 6.15% ÷ 4 = $15.375. Through all three cases the note's market price stays near $1,000, because each reset keeps the coupon current.

Common Mistakes

1. Thinking an FRN has no price risk. Its interest-rate duration is small, but a widening credit spread still pushes the price below par. Government FRNs carry far less of this than corporate FRNs.
2. Confusing the reference rate with total yield. The coupon is reference rate plus spread; quoting only the benchmark understates what the note pays.
3. Ignoring reset frequency. A note that resets quarterly can lag a fast rate move for up to three months. Shorter reset periods track the market more closely.
4. Assuming income is stable. FRN cash flows fall when rates fall. Investors relying on a steady coupon can be surprised by a lower payment after a rate cut.

Frequently Asked Questions

Q: What is a floating-rate note in one sentence? A floating-rate note is a bond whose coupon resets on a schedule to a market reference rate plus a fixed spread, so its interest payments move with short-term rates.

Q: Why does a floating-rate note hold its price when rates rise? Because the coupon resets upward to match higher rates, the note does not need to trade at a discount to stay competitive, so its price stays near par rather than falling like a fixed-coupon bond.

Q: What is the spread on an FRN? The spread, or quoted margin, is a fixed number of basis points added to the reference rate. It compensates for the issuer's credit risk and stays constant for the life of the note.

Q: Do floating-rate notes protect against all risk? No. They sharply reduce interest-rate price risk but still carry credit risk, and their income falls when rates fall, so they are not a guaranteed steady payout.

Q: What reference rates do FRNs use today? US Treasury FRNs reset to the 13-week Treasury bill rate, while many corporate and bank FRNs reset to SOFR, which replaced LIBOR as the main US benchmark.

Sources

1. Investopedia. "Floating-Rate Note (FRN)." https://www.investopedia.com/terms/f/frn.asp
2. TreasuryDirect. "Floating Rate Notes." https://www.treasurydirect.gov/marketable-securities/floating-rate-notes/
3. Federal Reserve Bank of New York. "Secured Overnight Financing Rate Data." https://www.newyorkfed.org/markets/reference-rates/sofr
4. SEC Investor.gov. "Bonds." https://www.investor.gov/introduction-investing/investing-basics/investment-products/bonds-or-fixed-income-products

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.