What is a floating rate note?

Answer 1

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