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Saturday, July 24, 2010

Floating Rate Notes




Floating Rate Notes are debt obligations similar to Bonds wherein one person borrows money from an investor for his business purposes and pays a periodic interest, with a slight difference being the fact that, the interest paid out is not fixed. The interest paid out would vary with the prevailing market interest rates. There is usually a base interest rate and a spread fixed with each issue. The base interest rate could the Prime Lending Rate prevalent among banks in the country of issue or any other standard interest rate commonly accepted by debt investors.

Let us understand what FRN’s are in detail with 2 examples. Here you are the investor who is investing Rs. 1 lac in both types of instruments.

Company A is issuing normal bonds that pay a coupon* of 8% every year. So this is how your future coupon payments would be

Year 1 – Rs. 8,000/-
Year 2 – Rs. 8,000/-
Year 3 – Rs. 8,000/-
Year 4 – Rs. 8,000/-
Year 5 – Rs. 8,000/-

Company B is issuing Floating Rate Notes that pay a coupon* of Prime Lending Rate in India + 50 basis points*

Year 1 – PLR is 7% so Coupon = 7.5% i.e., Rs. 7,500/-
Year 2 – PLR is 8% so Coupon = 8.5% i.e., Rs. 8,500/-
Year 1 – PLR is 10% so Coupon = 10.5% i.e., Rs. 10,500/-
Year 1 – PLR is 6% so Coupon = 6.5% i.e., Rs. 6,500/-
Year 1 – PLR is 7% so Coupon = 7.5% i.e., Rs. 7,500/-

The interest/coupon payment made out to the investor changes every year and is not fixed. In years where the benchmark rate is greater the investor gets a higher coupon payment and in years where the benchmark rate is lower, they get a lower coupon.


*Coupon – Coupon is the official term used for the rate of interest paid on Bonds and other debt instruments like FRNs.
*basis points – This is the official term used for the spread (extra coupon) usually issued by debt instrument issuers. 100 basis points = 1% rate of interest



Why do companies issue Floating Rate instruments?

During times when cash is hard to raise for business expansion purposes, the market interest rates are usually high. Though this is not a permanent situation, if a company offers a fixed rate bond at the prevailing rate, it would have to continue to make the payments until the bond maturity. There are chances that the situation may improve and market interest rates come down. In such cases, companies that raised money at higher rates a few years/months back are going to lose a lot of money.


Floating rate notes are an easy alternative wherein, the payments made out to investors are going to be in line the prevailing market interest rates.

Companies that need cash and predict the market rates to fall usually issue FRNs

Why people invest in Floating Rate instruments?

During times of economic boom, interest rates are usually lower. In cases where an investor has bought a bond at the prevailing low interest rate and after a year or so the market interest rates rise, he cannot exit the bond and invest in the newer higher returns instrument. He would have to hold the low coupon paying bond till maturity.

Floating rate notes are an easy alternative wherein, the payments made out by the notes issuer is going to be in line the prevailing market interest rates.

Types of FRNs

1. Callable FRNs

These are FRNs where the issuer has the option of calling back the notes and pay off the principal outstanding along with applicable interest at any time during the note tenure. Company’s usually do this if the prevailing market rates are very low. They can call back their existing FRN and issue fixed rate bonds at the prevailing low interest rates. Such an action by the note issuer is a disadvantage to the investor

2. Capped FRNs

These are FRNs that have a cap to the maximum interest/coupon payment that would be made out by the note issuer

3. Floored FRNs

These are FRNs that have a set minimum interest/coupon payment that would be made out by the note issuer

4. Collared FRNs

These are FRNs that are a combination of both capped and floored FRNs. Here the minimum and the maximum interest rate payable is fixed and usually the coupon payments done to the investors varies between the set range.

5. Reverse or Inverse FRNs

These are FRNs where the coupon payment moves in a direction opposite to the set benchmark rates. If the market interest rates rise, the coupon payment falls. Similarly if the market interst rates fall, the coupon payment rises.

6. Stepped FRNs

These are FRNs where the coupon payment rate is set or reset many times during the life of an FRN. For ex: a company can say that it would pay the below coupon:

Year 1 – Benchmark rate + 50 basis points
Year 2 & 3 – Benchmark rate + 75 basis points
Year 4 – Benchmark rate
Year 5 – Benchmark rate + 50 basis points

Here, though the coupon amount is going to vary every year, the investor can clearly predict the amount that he would receive from the note issuer.


Benefits of FRNs

As investors the major benefit of FRNs is “Portfolio Diversification & Risk Management”

A portfolio is one that is diversified and can weather market risks. FRNs could be a valuable addition to an investors portfolio because it would help the portfolio earn higher returns when the market interest rates are on an upward trend

Usually when the stock markets are down, the interest rates are up. So FRNs can help us offset some of the losses that we may incur in the stocks through higher returns in FRN instruments

Drawbacks of FRNs

As with all investment instruments, FRNs have their inherent risks too. If the prevailing market interest rates go down steeply, the returns on our investments may go down too. So it is a good approach to carefully study the probably direction of market interest rates before investing …

Note: FRNs are still not very popular in India. There are a few options available but not many :)

Happy Investing!!!
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All the contents of this blog are the Authors personal opinion only and are not endorsed by any Company. This website or Author does not provide stock recommendations. The purpose of this blog is to educate people about the financial industry and to share my opinion about the day to day happenings in the Indian and world economy. Contents described here are not a recommendation to buy or sell any stock or investment product. The Author does not have any vested interest in recommending or reviewing any Investment Product discussed in this Blog. Readers are requested to perform their own analysis and make investment decisions at their own personal judgement and the site or the author cannot be claimed liable for any losses incurred out of the same.