How do floating rate notes work, and why do they have almost no interest rate risk?
I see that floating rate notes (FRNs) are covered in CFA Level I Fixed Income. The textbook says their price stays near par because the coupon resets. But I don't fully grasp the mechanics — how does the coupon reset work, what's the reference rate, and why doesn't the price fluctuate like a fixed-rate bond?
Floating rate notes (FRNs) have coupons that adjust periodically based on a reference rate plus a fixed spread. This reset mechanism keeps the bond's price anchored near par and dramatically reduces interest rate risk.
Coupon Mechanics:
Coupon Rate = Reference Rate + Quoted Margin
At each reset date (typically quarterly), the coupon is recalculated using the then-current reference rate. Common reference rates include SOFR (Secured Overnight Financing Rate), which replaced LIBOR.
Example:
Dunbar Financial issues a 5-year FRN:
- Reference rate: 3-month SOFR
- Quoted margin: +120 bps (1.20%)
- Face value: $1,000
- Reset: Quarterly
If 3-month SOFR is currently 4.50%:
Coupon rate = 4.50% + 1.20% = 5.70% annualized
Quarterly payment = $1,000 x 5.70% / 4 = $14.25
Next quarter, if SOFR rises to 4.85%:
New coupon = 4.85% + 1.20% = 6.05%
Quarterly payment = $1,000 x 6.05% / 4 = $15.13
Why the Price Stays Near Par:
At each reset date, the FRN's coupon adjusts to reflect current market rates. Since the bond is always paying a "market rate" plus the credit spread, there's no reason for the price to deviate significantly from par — the bond is effectively a new issue every reset period.
Duration of an FRN:
Between reset dates, an FRN behaves like a short-term fixed-rate bond maturing at the next reset. Therefore:
Effective duration of FRN ≈ Time to next reset date
For a quarterly-reset FRN, the maximum duration is approximately 0.25 years (3 months). Compare this to a 5-year fixed-rate bond with duration around 4.3 years.
When FRNs DO Move Away from Par:
- Credit spread changes: If Dunbar's creditworthiness deteriorates and the market demands +180 bps instead of +120 bps, the FRN's price falls below par because its quoted margin is "stale."
- Between reset dates: If rates move sharply between resets, there's a small price deviation until the next coupon adjustment.
- At issuance vs. current market spread: The "discount margin" may differ from the quoted margin.
Exam Tip: FRNs have minimal interest rate risk but still carry credit risk. If a question asks which bond has the lowest duration, the FRN is almost always the answer.
Explore floating rate instruments in our CFA Level I Fixed Income course.
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