Floating Rate Notes (FRNs):
When interest rates are high and the general outlook is either stable or indicating the possibility of a downward trend in return, then an investor would obviously consider purchasing a long-term fixed rate bond. The rationale behind such a strategy is simply to secure the prevailing high returns and also to benefit from any appreciation of capital that may occur when the expected future scenario is of declining rates of interest. If the present rates of interest are discouragingly low and if interest rates are expected to increase in future, then the investor cannot choose to go for long-term or medium-term investments whose coupon rates are based on the prevailing lower interest rates. He naturally looks for instruments which would pay interest that varies with the trend prevailing in the future years. This need of the investor led to the innovation of Floating Rate Notes. From the point of view of issuers, it should be noted that there are no conditions attached to the use of funds and therefore, the borrowers are free to use them for their general corporate needs. However, since many of these issues are unsecured, sovereign borrowers in developing countries are required to obtain a state guarantee while corporate entities require a bank guarantee.
Definition and Mechanism
A Floating Rate Note (FRN) is a bond issued for medium to long-term, which pays coupons that are pegged to the level of a certain floating index, which is called reference index. Let us consider a five-year FRN with coupons referenced to the six-month LIBOR (London Inter-bank Offer Rate) paying coupon semi-annually and the default risk premium set at 0.125%. This implies that during the five-year tenure of the bond, the coupon interest paid will be varying according to the LIBOR. For example, if the LIBOR is 6.6% the next coupon payment on a $1000 FRN will be equal to 0.5 (0.066 + 0.00125) (1000) = $33,625. If, on the other hand, for the next reset date the six month LIBOR comes down to 5.7%, then the coupon payment will be equal to 0.5 (0.057 + 0.00125) (1000) = $29,125.
In a basic floating rate note, the following are the five important features:
- Reference Index
- Quoted Margin to Reference Rate
- Reset Frequency
- Observation Date
- Maturity Date.