U.S. Treasury floating rate notes, or FRNs, are debt investments with a variable interest rate tied to the latest 13-week U.S. Treasury Bill rate. When this T-Bill rate increases, the FRN interest rate will adjust accordingly and allow investors to earn higher coupon payments. Investors buy FRNs because they provide protection against rising interest rates, as the interest rate on FRNs adjusts periodically to reflect changes in market rates. This makes FRNs attractive for investors seeking higher yields in a rising rate environment.
Summary:
- Floating rate notes (FRNs or floaters) protect investors against rising interest rates and can generate increased yields in a rising rate environment.
- FRNs have a variable rate component indexed against the most recent new-issue 13-week T-Bill rate. When the T-Bill rate fluctuates, the FRN interest rate fluctuates as well. Rising rates are advantageous to FRN holders.
- The other component of the FRN interest rate is the “spread”, which is a fixed rate set by U.S. Treasury at the time of an FRN auction. Adding the spread to the 13-week T-Bill rate gets you the FRN rate.
What Is a Floating Rate Note?
A floating rate note (FRN) is a debt instrument that pays interest at a variable rate, which adjusts periodically based on the latest 13-week U.S. Treasury bill rate.
U.S. Treasury FRNs were introduced in 2014. These are 2-year notes that pay interest quarterly (every three months). U.S. Treasury FRNs are exempt from state and local taxes like other Treasuries. Federal taxes on FRNs must be paid every year.
Unlike fixed-rate bonds, which pay a constant interest rate throughout their life, the interest payments on FRNs adjust in response to fluctuations in the underlying index rate, which is the 13-week T-Bill rate.
As a result, FRNs protect investors in an environment with rising interest rates and provide a higher return from increased coupon payments.
How Do Floating Rate Notes Work?
U.S. Treasury floating rate notes have an interest rate comprised of an index rate and spread. The index rate will adjust weekly based on changes in the interest rates while the spread is fixed. Let’s walk through each component:
- Index Rate: The interest rate on an FRN is tied to an index rate. For U.S. Treasury floating rate notes, this index rate is the highest discount rate of the most recent 13-week Treasury Bill. Because new-issue 13-week T-Bills are auctioned every week, the index rate of the FRN is also reset every week.
- Spread: In addition to the index rate, the U.S. Treasury will pay an additional fixed percentage, known as the spread. This spread is fixed for the life of an FRN and determined at the time of auction.
- Interest Reset Period: The interest rate on an FRN adjusts every week based on the changes in the 13-week Treasury Bill rate.
Interest is paid every three months until maturity, but interest payments are calculated daily.
Floating Rate Note Example:
Let’s walk through an example of floating rate notes with some illustrative numbers.
Let’s say you buy an FRN with a principal amount of $1,000. The interest rate on this FRN is determined by the 13-week Treasury Bill rate plus a spread of 0.125%.
- Initial Interest Payment:
- At the time of purchase, let’s assume the 13-week Treasury Bill rate is 5.5%.
- The interest rate for the FRN would be 5.5% (13-week T-Bill rate) + 0.125% (spread)= 5.625%.
- Since the interest is calculated daily, the interest payment for that week is approximately $1.09, or $1,000 times the interest rate of 5.625% times seven (the number of days in a week) divided by 360 (the number of days used for annual calculations).
- Subsequent Interest Payment:
- After a week months, suppose the 13-week T-Bill rate rises to 5.6%.
- The new interest rate for the FRN would be 5.6% (13-week T-Bill rate) + 0.125% (spread)= 5.725%.
- Since the interest is calculated daily, the interest payment for that week is approximately $1.11, or $1,000 times the interest rate of 5.725% times seven (the number of days in a week) divided by 360 (the number of days used for annual calculations).
As illustrated, when the index rate of the 13-week Treasury Bill rises, the interest payment on the FRN also increases. This mechanism allows FRN holders to benefit from rising interest rates, unlike fixed-rate bondholders, who receive a constant interest payment regardless of market rate fluctuations.
What Happens to a Floating Rate Note When Interest Rates Go Down?
Because the interest rate of a floating rate note is tied to the 13-week T-Bill interest rate, if the T-Bill rate goes down, then the interest rate on the FRN will also decline.
How Is The Spread Calculated?
The spread for FRNs represents the margin added to the index rate to determine the total interest rate payable on the note.
The spread for U.S. Treasury FRNs is determined at the time of the initial auction. It remains fixed for the life of the note.
During the auction, bids are placed by participants, and the spread is set at the highest rate at which the quantity of offered notes will be fully awarded. This means that all successful competitive and non-competitive bidders receive the FRN at the same spread.
The spread is added to the index rate (e.g., the high yield of the most recent 13-week Treasury bill auction) to determine the interest rate for the upcoming period.
How Do Investors Use Floating Rate Notes in a Portfolio?
Floating rate notes offer investors protection against rising interest rates due to their ability to adjust coupon payments in line with market interest rates. FRNs pay a stable income stream like other Treasuries and fixed-income securities, but FRNs have the potential for increased coupon payment income if interest rates rise.
FRNs are an ideal cash complement since they’re backed by the full faith and credit of the U.S. government, so there’s effectively no default risk. As a result, it can be a viable alternative to holding cash in a regular bank or savings account for some savers and investors.
Some investors use FRNs to hedge against inflation and the negative impact of rising rates on fixed-rate bonds. In that sense, FRNs are sometimes compared alongside TIPS (whose principal fluctuates based on inflation) and I Bonds (whose interest rate changes every six months based on inflation).
What Are the Tax Implications of Floating Rate Notes?
Interest income from U.S. Treasury floating rate notes is exempt from state and local income taxes. However, it is still subject to federal income tax. This must be paid annually.
You’ll have a capital gain if you sell or redeem an FRN for more than your purchase price (or adjusted basis). Conversely, if you sell or redeem it for less than your purchase price, you’ll have a capital loss. It’s a short-term capital gain or loss if held for one year or less. It’s a long-term capital gain or loss if held for more than one year.
What Are the Auctions Dates for Floating Rate Notes?
The auctions for floating rate notes are announced in the second half of January, April, July, and October (once every three months).
Reopening auctions of a 2-year FRN are announced in all other months of the year. The announcements occur in the second half of February, March, May, June, August, September, November, and December.
A reopening auction is when the U.S. Treasury issues additional amounts of a previous FRN.
Here is a handy table outlining the FRN auction schedule:
| New-Issue FRN Auction Months | FRN Reopening Auction Months |
|---|---|
| January | February, March |
| April | May, June |
| July | August, September |
| October | November, December |
All floating rate notes issued in reopening auction months will have the same CUSIP number, maturity date, and spread as the FRNs in the most recent new-issue auction.
An FRN issued in the months of the right-hand column will be the same as the FRN issued in the month of the corresponding column on the left, except for a potential difference in purchase price.
The U.S. Treasury auction schedule will also show you the exact dates for new-issue FRNs being issued or reopened.
What Are The Risks of Floating Rate Notes?
Like Treasury bills, notes, and bonds, floating rate notes are backed by the full faith and credit of the US government. Therefore, the default risk of U.S. Treasury floating rate notes is virtually none.
There are certain things to consider when you buy FRNs:
- Because an FRN is tied closely with the 13-week T-Bill rate, any drop in the rate will result in a lower coupon payment for the investor.
- The spread in FRNs is not always positive. For example, the spread on 2-year FRNs issued in April 2022 had a negative spread of -0.075%. In that case, the yield on this FRN would be lower than the current 13-week Treasury bill yield.
- FRNs may not have a very liquid secondary market. While you can technically sell FRNs before maturity, the market for selling FRNs is not as liquid as for T-Bills.
How Can I Buy Floating Rate Notes?
You can purchase floating rate notes through TreasuryDirect, your bank, or your brokerage.
To buy floating rate notes in TreasuryDirect, log into your account and click the BuyDirect tab. Follow the prompts to buy FRNs, specify the purchase amount, and other information.
To buy FRNs in your brokerage account, such as Fidelity, E*Trade, or Vanguard, you can typically find the option to buy U.S. Treasury FRNs in the Fixed Income or Bonds section. Look for new-issue Treasuries, under which new-issue FRNs should show up if they have been announced.
We also highly suggest looking into floating rate note ETFs like USFR and TFLO, which hold a basket of floating rate notes. As professionally managed funds, this can be a more accessible way for the average investor to receive exposure to FRNs.
