Floating Rate Notes

Floating Rate Notes

Investors are constantly seeking instruments that provide attractive returns while managing risk. One such instrument that has gained popularity is the Floating Rate Note, or FRN. FRNs offer investors a unique investment opportunity by providing a variable interest rate that adjusts periodically based on a reference rate. These instruments can serve as a hedge against rising interest rates and offer the potential for higher returns compared to fixed-rate bonds. By understanding the mechanics and advantages of FRNs, investors can make informed decisions and enhance their investment portfolios. 

What is a FRN? 

A FRN is a type of bond that has a variable interest rate. Unlike traditional fixed-rate bonds, which offer a fixed interest payment throughout the life of the bond, FRNs have interest payments that adjust periodically based on a reference rate. The reference rate is typically a benchmark interest rate, such as the London Interbank Offered Rate LIBOR or the US Treasury Bill rate. 

The interest rate on an FRN is usually expressed as a spread or margin above the reference rate. One of the key benefits of FRNs is their ability to protect investors against interest rate risk. When interest rates rise, the interest payments on FRNs increase, providing investors with higher returns. This feature makes FRNs a valuable addition to diversified investment portfolios, providing a hedge against interest rate fluctuations 

Understanding FRNs 

FRNs have certain characteristics that make them unique and attractive to investors. Here are some key points to understand about FRNs: 

Interest Rate Adjustments: The interest rate on an FRN is typically adjusted every three to six months, depending on the terms of the note. This adjustment ensures that the interest payment reflects the prevailing market rates. 

Maturity Dates: Like other bonds, FRNs have a maturity date, which is the date when the principal amount is repaid to the bondholder. The maturity of FRNs can range from a few months to several years, depending on the issuer’s needs. 

Diverse Issuers: FRNs are issued by a variety of entities, including corporations, governments, and financial institutions. This diversity provides investors with a range of options to choose from, allowing them to tailor their investments to their risk appetite and investment objectives. 

FRN pricing and valuation 

 The pricing and valuation of FRNs can be complex due to the variable interest rate component. The key factors that influence the pricing and valuation of FRNs include: 

Reference Rate: The reference rate plays a crucial role in determining the interest payments on FRNs. As the reference rate changes, the interest payments on FRNs will adjust accordingly. 

Market Demand: The overall demand for FRNs in the market can affect their pricing. If demand exceeds supply, the prices of FRNs may rise, leading to lower yields and vice versa. 

Discount Margin: The discount margin is a measure used to compare the yields of FRNs with similar maturity profiles. It represents the additional yield investors require above the reference rate to compensate for the credit risk associated with the issuer. 

FRN discount margin 

When considering an investment in FRNs, one essential metric that investors should analyse is the discount margin. The discount margin serves as an important indicator for evaluating the risk and return potential of FRNs. In this section, we will delve into the concept of the discount margin and its significance in the context of FRNs. 

The discount margin represents the additional yield that investors demand above the reference rate to compensate for the credit risk associated with the issuer of the FRN. It is a measure of the spread between the FRN’s yield to maturity and the risk-free rate, such as the US Treasury Bill rate or the Singapore Government Securities rate. By assessing the discount margin, investors can gauge the perceived creditworthiness of the issuer and determine whether the potential return adequately compensates for the associated risk. A higher discount margin implies that investors perceive the issuer of the FRN to have a higher level of credit risk.  

Example of a FRN 

To illustrate how FRNs work, let’s consider an example. Suppose a Singapore-based corporation, ABC Corporation, issues a three-year FRN in the US market. The FRN has a reference rate of the Singapore Interbank Offered Rate, or SIBOR plus a spread of 1.5%. The initial reference rate is 1.75%, making the FRN’s interest rate 3.25%. 

As an investor based in Singapore or the US, if you decide to invest US$10,000 in this FRN, your interest payments will adjust periodically based on changes in the SIBOR. Let’s assume the SIBOR increases to 2.25% after six months, resulting in an interest rate adjustment to 3.75%. 

For the first six months, your interest payment would be US$325, calculated as (US$10,000 x 3.25% / 2). After the interest rate adjustment, your interest payment for the remaining period would be $375, calculated as (US$10,000 x 3.75% / 2). 

As an investor, you will receive the interest payments throughout the life of the FRN. At maturity, ABC Corporation will repay the principal amount of US$10,000. It’s essential to consider the creditworthiness of the issuer, ABC Corporation, and evaluate the risks associated with investing in the FRN. 

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