Explain Floating Rate Bonds versus Fixed-rate Bonds

Floating rate bonds (also called “floating rate note” – FRN) contrasts with a fixed-rate bond. This bond usually has the same features as a plain vanilla bond except that it does not have a fixed coupon, i.e. the rate payable on the bond is not fixed. Instead, the rate payable is linked to some benchmark rate. The benchmark rate can be any rate that “floats”, i.e. changes frequently with market conditions, but it is a rate that is quoted regularly and is reliable in terms of reflecting market conditions accurately. Examples of benchmark rates are:

  • Prime rate. This is the rate charged by banks on overdraft facilities to prime clients, and they are usually the same. They are usually quoted by the banks on a permanent basis.
  • Interbank lending rates. In most countries a neutral organisation (such as an exchange) gathers in a variety of rates at which a number of the large banks will lend to one another for various periods, for example overnight, 30 days, 60 days, 91 days, 182 days and so on. Here we call them IBAR (interbank agreed rates). The neutral organisation usually calculates and publishes daily arithmetical averages for each rate after lopping of the highest and the lowest.
  • 3-month BA rate (i.e. the rate on 3-month bankers’ acceptances). This rate occupied a high profile position in many countries in the past, but the instrument is no longer as widely traded.
  • 91-day treasury bill tender rate. Most central banks, on behalf of their governments, conduct weekly treasury bill tenders for various terms. In most countries these rates are published weekly and have high credibility in the market.