Floating Rate Notes are bonds in which interest rate depends on the interest rate prevailing in the market. The interest rate paid to the bondholder at regular intervals comprises of the interest rate prevailing in the market and ‘spread’, which is a rate that is fixed when the prices of the bond are being fixed and it remains constant till the maturity period of the bond.
Most of the floating rate notes pay interest after every three months. The interest rate is calculated at the beginning of the quarter by adding the interest rate prevailing in the market on that day with the ‘spread’. Floating Rate Notes do not face any interest risk since if the interest rate in the market is high, the interest paid on Floating Rate Notes is also increased. Floating Rate Notes only face credit risk.
Some of the indexes used to calculate the interest rate as per market rates are London Interbank Offered Rate for US Dollars and other currencies (LIBOR), Fed Funds Rate (FFR), Constant Maturity Treasury Index (CMT) and Prime Rate.
Also known as Floaters or Floating Rate bonds, Floating Rate Notes were issued for the first time during the late 1970s when interest rate was volatile.
In the United States, some of the major issuers of the Floating Rate Notes are Federal Home Loan Banks, Federal Home Loan Mortgage Corporation and Federal National Mortgage Association while banks are the prominent issuers of the Federal Fund Rates in the United Kingdom.
In primary markets, Floating Rate Notes are not traded through stock exchanges but are traded through dealers. In the secondary market, the value of the floating rate notes depend on the period left till maturity, interest rate prevailing in the market, credibility of the issuer and outstanding amount on the bonds.
The interest rate on floating rate notes may be changed weekly, quarterly, semi-annually and annually depending on the type of bond. For eg., for T-bill floating rate notes, interest rate is changed every week as auctions for T-bills are held every week.
Floating Rate Notes are ideal for those investors who think that interest rate is going to rise.