Floating Rate Notes Offer Protection Against Rising Interest Rates

Floating rate notes (FRNs) provide investors with a mechanism to mitigate the risks associated with rising interest rates. Unlike fixed-rate bonds, FRNs have coupon rates that adjust periodically based on a benchmark interest rate, such as LIBOR or SOFR, plus a spread.

How Floating Rate Notes Work

The interest rate on an FRN is reset at predetermined intervals, typically quarterly or semi-annually. This reset is based on the prevailing benchmark rate at the time of the adjustment. For example, an FRN might pay LIBOR plus 100 basis points. If LIBOR increases, the coupon payment on the FRN also increases.

Benefits of Investing in Floating Rate Notes

Protection Against Rising Rates: The primary advantage of FRNs is their ability to maintain their value in a rising interest rate environment. As rates increase, the coupon payments adjust upwards, offsetting the negative impact of higher rates on bond prices.
Lower Interest Rate Risk: FRNs have lower interest rate risk compared to fixed-rate bonds. Their prices are less sensitive to changes in interest rates because the coupon rates are regularly adjusted.
Stable Income Stream: While the coupon payments on FRNs fluctuate, they provide a relatively stable income stream that keeps pace with prevailing interest rates.

Considerations When Investing in Floating Rate Notes

While FRNs offer protection against rising rates, they also have some drawbacks:

Lower Yields: FRNs typically offer lower yields than fixed-rate bonds, especially in a low-interest-rate environment.
Credit Risk: Like all bonds, FRNs are subject to credit risk. If the issuer defaults, investors may lose their principal.
Complexity: Understanding the terms and conditions of FRNs, including the benchmark rate and spread, can be complex.

Conclusion

Floating rate notes can be a valuable addition to a diversified investment portfolio, particularly for investors concerned about the potential for rising interest rates. By providing a hedge against rate increases, FRNs can help maintain the value of a bond portfolio and provide a stable income stream.