A floating rate note is a type of financial instrument that is structured to include a floating or variable rate of interest rather than a flat or fixed rate. Sometimes known simply as a floater, this type of note is reviewed two or three times during the calendar year and the rate of interest applied to the current balance is adjusted based on what is happening with the prevailing average rate of interest as reflected in a specific money market index. Floating rate notes (FRNs) are usually issued for periods of three to five years and are often used by investors who believe that the shifts in the prevailing interest rate over the life of the bond will result in an equitable level of return.
There is some difference of opinion regarding whether a floating rate note should be referred to as debt or as an investment. This is because the note functions in a manner that is similar to bonds, but also has some of the characteristics of an adjustable rate mortgage. This has led some financial professionals to focus more on certain aspects of the FRN while tending to downplay others, depending on whether those professionals consider the note to be a true debt instrument or an investment.
Regardless of how the floating rate note is classed, the potential for earning a return from this type of financial instrument will depend heavily on what happens with the interest rate from the time the note is issued until it reaches maturity. Typically, shifts in the rate applied to the note’s balance will be based on what is happening in a specific money-market index, with that index identified in the terms and conditions related to the note itself. This creates a situation in which the investor who purchases the floating rate note will want to monitor the activity on that index closely, and attempt to determine if the shifts are likely to be favorable over the duration of the note.
Some investors may find the floating rate note preferable to any type of fixed rate bond issue. This is because the potential with a fixed rate instrument is somewhat limited. By contrast, the floating or variable rate connected with this type of note could pave the way for earning a higher return overall, if the prevailing interest rates should increase over time. While any debt instrument with a fixed rate is less volatile, the floating rate note provides the possibility of earning a greater return even as it presents a greater risk.