Floating Rate Notes

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.

Issuers of the Floating Rate Notes

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.

Types of Floating Rate Notes

  1. Capped Floating Rate Notes are Floating Rate Notes that set a maximum limit for the interest rate beyond which the interest rate cannot be paid to the bondholder despite a higher interest in the market.
  2. Floored Floating Rate Notes are Floating Rate Notes that have a minimum limit beyond which the interest rate cannot decrease even if the prevailing interest rate in the market is lower.
  3. Collared Floating Rate Notes are Floating Rate Notes that comprise both maximum and minimum coupons.
  4. Perpetual Floating Rate Notes are bonds which do not have any maturity date and regularly pay interest to the bondholder.
  5. Structured Floating Rate Notes are Floating Rate Notes that do not pay changed interest rate as per the prevailing market rates. But such bonds set a highest limit beyond which interest rate would not rise and a lower limit beyond which the interest rate paid to the bondholder would not decrease.
  6. Reverse Floating Rate Notes pay higher interest to the bondholder if the interest rate prevailing in the market is low and vice versa. Suppose an index put the interest rate at 8 per cent, the interest rate paid to the bondholder may be 6 per cent and if the interest rate in the market is 5 per cent, the interest rate paid to the bondholder maybe around say 8 per cent. Such Floating Rate Notes help investors to benefit from a decline in interest rate for short-term.
  7. Step up Recovery Floating Rate Notes are Floating Rate Notes in which interest rate paid to the bondholder is increased over the interest prevailing in the market as time goes.
  8. T-bill Floaters are Floating Rate Notes which are issued by the US government every week.

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.