Floating Rate Notes

A fixed-rate bond locks in its coupon for the life of the bond, which means its price has to move up or down whenever market interest rates change, since the fixed coupon becomes relatively more or less attractive. A floating rate note (FRN) avoids most of that price sensitivity by resetting its coupon periodically — say, every three months — to a current reference rate plus a fixed spread agreed at issuance. Because the coupon itself moves with the market, the note's price stays close to its face value between reset dates rather than swinging with every rate change the way a fixed-coupon bond's price does.

The fixed spread over the reference rate is the part that reflects the issuer's credit risk and doesn't reset; it's set once at issuance and stays constant for the note's life, while only the reference-rate component of the coupon resets. This means an FRN still carries credit risk exposure to the issuer — its price can still move if the market's view of that issuer's creditworthiness changes — but it carries very little exposure to broad interest-rate moves.

A worked example

A 5-year FRN might pay a reference rate (say a benchmark short-term rate) plus a 1.5% spread, resetting quarterly. If the reference rate rises from 3% to 5% over the note's life, the coupon rises along with it each quarter, so the note's price stays near $100 the whole time — compare this to a fixed-rate 5-year bond issued at the same 4.5% initial coupon, whose price would have fallen noticeably as market rates rose past its locked-in rate.