Different Types of Floating-Rate Notes

A floating-rate note is a type of security that comes with a variable rate and regular interest adjustments. Often, the interest rate is the prevailing rate on the money market index, plus a fixed profit margin or spread. In the US, the index used for FRNs is the federal funds rate. However, in Europe, the LIBOR (London interbank offered rate) or Euro interbank offered rate serves as the index for this type of security. In the US, FRNs are usually issued by government entities and backed by loans that are also insured by the government. Therefore, floating notes are considered low risk. Meanwhile, in Europe, banks and other financial companies commonly issue FRNs. The market offers several types of floating rate notes.

Plain Floating Rate Note

This is the simplest type of floater. If you invest in this kind of FRN, all you have to remember is that the interest rate applicable to your investment increases proportionately to the rise in the interest rate used in the money market or capital market index. In essence, you gain money as the index rate increases.

Capped Note

This type of FRN minimizes the seller's risk because it puts a limit on the coupon rate. This means that even if the interest rate in the index surges, the investor’s gain will be limited only to the maximum interest rate set by the note's seller.

Floored Note

Unlike the capped floater, this type of note protects the buyer. If you invest in a floored FRN, you will get a guaranteed minimum coupon rate. Thus, even if the interest rate drops, you can still get a good return on your investment.

Collared Floater

This type of security combines the characteristics of floored and capped notes. Collared FRNs offer both minimum and maximum coupon rates to limit return to the investor and risk to the seller via a specified range of interest rates.

Perpetual FRN

The main feature of this type of floater is the absence of a definite maturity date. As a result, investors receive interest income constantly and in perpetuity. More often than not, perpetual FRNs are considered capital investments.

Reverse Floating Rate Note

This type of floater, which is also known as an inverse FRN, offers the same structure as a plain or regular floating rate note except for how the applicable coupon rate is computed. In essence, the coupon rate for this type of debt security is inversely proportional to the reference rate movement. Investors in reverse floaters usually receive huge profits from declining rates.

Flip-flop Note

This type of FRN offers investors a type of security that has a fixed rate and a floating rate. If the floating interest rate falls below the fixed coupon rate, you can opt to receive profit using the specified fixed rate. However, if the interest rate surpasses the fixed coupon rate, you can choose the prevailing floating rate to earn higher income.

blog comments powered by Disqus