Types of FRNs
In an era of innovations, while changing needs and preferences of the investors trigger introduction of newer FRNs, the borrowers' funding specifications also necessitate the sprouting of new varieties of FRNs. Some of the important varieties are listed hereunder:
- Flip-flop FRNs
- Mismatch FRNs
- Mini-max FRNs
- Capped FRNs
- Structured FRNs
- Perpetual FRNs
- Deleveraged FRNs
- Inverse FRNs.
The World Bank came out with an issue of FRNs in 1985, with a spread of 50 basis points over the three-month US Treasury Rate and a perpetual life. It also provided the note holder an option of converting the FRN into a three month flat yield at the end of every sixth months. The investor could again go back to floating rate with perpetual maturity if he desires so.
These are also called rolling rate FRNs.
These FRNs consist of minimum and maximum coupons. Investors benefit in terms of high spread (over the LIBOR), but have to agree to a minimum rate as well as a maximum rate on their notes, the differential between the two being very small. These are also referred to as Collared FRNs. For example, a bond with 5-year maturity and coupon interest payable six monthly at LIBOR - 0.50% subject to a cap of 8.25% and a floor of 5.5%.
Under capping arrangements, the FRNs issued are pegged to an interest rate cap. This means that the issuer need not pay interest beyond the ceiling level even if the LIBOR shoots up to more than that level. In order to protect the interests of the investors and make the bond attractive, normally higher margins are offered on such FRNs.
Structured FRNs (Variable Rate Notes)
This is one of the latest innovations which is issued for longer terms (sometimes perpetual also) with variable interest spreads with margins over LIBOR going up for later maturities. Margins for the subsequent dates in this regard are fixed either by auctioning or through a mutual agreement.
These are also called irredeemable or unrated FRNs and are akin to a form of capital.
The reference rate is adopted as a percentage of the value of reference index. For example, the coupon will be determined as 75% of LIBOR + 0.7%. It may be noted that the reference rate is not taken as the full value of LIBOR.
Inverse Floating Rates
The coupon rate increases when the LIBOR rate decreases and vice versa. This benefits the investors when the rate of interest in the market is in the declining trend.
Risks Associated with FRNs
Basically there are two risks associated with FRNs. One is the interest rate risk and other default risk.
Interest Rate Risk
Normally short-term interest rates have higher volatility than long-term interest rates. So an FRN holder may hedge against such risk by taking positions in Eurodollar futures contracts or interest rate swaps. The risk in institutions holding a portfolio of FRNs with different reset dates, is very similar to a portfolio of short-term paper issued by the respective companies with maturity dates coinciding with various reset dates.