A floating-rate note (FRN) is a debt security with a variable interest rate tied to a benchmark, including the U.S. Treasury note rate or the prime rate.
How do FRNs work for municipalities?
Many bonds have a fixed interest rate, meaning it does not change throughout the bond’s term. However, FRNs make up a large portion of the U.S. investment-grade bond market and have variable interest rates. That means interest rates can change throughout the bond’s term.
An FRN’s interest rate is tied to a benchmark rate, such as the London Interbank Offered Rate (LIBOR) or the U.S. Federal Reserve’s federal funds rate. Most FRNs pay investors their coupon payments quarterly. However, they may pay monthly, semi-annually, or annually.
As for the interest rate, the issuer doesn’t have to change the rate at the same pace as the prevailing rates. In the bond prospectus, the issuer must provide how often it adjusts the rate and how it is tied to the benchmark.
The FRN bondholders still have default risk if the issuer is bankrupt and interest rate risk for the bond to underperform the market, but FRNs can attract investors because they reduce the opportunity cost of buying a fixed-rate bond when surrounding rates are changing. Market price won’t change as much with interest rate changes since the FRN’s rate is variable.
Municipalities can issue FRNs for terms of two to five years.
Rates are rising. A municipality issues an FRN with a three-year maturity that pays the federal funds rate + 0.2%. The rate resets quarterly. If the federal funds rate is 2% at the time of issue, the FRN will pay 2.2% the first quarter post-issue.
What’s important here?
If prevailing interest rates are rising, FRNs can be more attractive to investors. If rates are falling, they will be less attractive.