How do floating rate notes work, and why do they have almost no interest rate risk?

Floating rate notes (FRNs) have coupons that adjust periodically based on a reference rate plus a fixed spread. This reset mechanism keeps the bond's price anchored near par and dramatically reduces interest rate risk.

Coupon Mechanics:

Coupon Rate = Reference Rate + Quoted Margin

At each reset date (typically quarterly), the coupon is recalculated using the then-current reference rate. Common reference rates include SOFR (Secured Overnight Financing Rate), which replaced LIBOR.

Example:

Dunbar Financial issues a 5-year FRN:

• Reference rate: 3-month SOFR
• Quoted margin: +120 bps (1.20%)
• Face value: $1,000
• Reset: Quarterly

If 3-month SOFR is currently 4.50%:

Coupon rate = 4.50% + 1.20% = 5.70% annualized

Quarterly payment = $1,000 x 5.70% / 4 = $14.25

Next quarter, if SOFR rises to 4.85%:

New coupon = 4.85% + 1.20% = 6.05%

Quarterly payment = $1,000 x 6.05% / 4 = $15.13

Why the Price Stays Near Par:

At each reset date, the FRN's coupon adjusts to reflect current market rates. Since the bond is always paying a "market rate" plus the credit spread, there's no reason for the price to deviate significantly from par — the bond is effectively a new issue every reset period.

Duration of an FRN:

Between reset dates, an FRN behaves like a short-term fixed-rate bond maturing at the next reset. Therefore:

Effective duration of FRN ≈ Time to next reset date

For a quarterly-reset FRN, the maximum duration is approximately 0.25 years (3 months). Compare this to a 5-year fixed-rate bond with duration around 4.3 years.

When FRNs DO Move Away from Par:

1. Credit spread changes: If Dunbar's creditworthiness deteriorates and the market demands +180 bps instead of +120 bps, the FRN's price falls below par because its quoted margin is "stale."
2. Between reset dates: If rates move sharply between resets, there's a small price deviation until the next coupon adjustment.
3. At issuance vs. current market spread: The "discount margin" may differ from the quoted margin.

Exam Tip: FRNs have minimal interest rate risk but still carry credit risk. If a question asks which bond has the lowest duration, the FRN is almost always the answer.

Explore floating rate instruments in our CFA Level I Fixed Income course.