Variable rate note

3 key takeaways

• Variable rate notes have interest rates that adjust periodically, usually in relation to a benchmark rate such as the LIBOR, prime rate, or U.S. Treasury bill rate.
• These notes provide investors with protection against rising interest rates, as the interest payments increase with the benchmark rate.
• Variable rate notes are commonly used by corporations and municipalities to manage interest rate risk and provide investors with a hedge against inflation.

What is a variable rate note?

A variable rate note (VRN), also known as a floating rate note (FRN), is a type of debt instrument that pays interest at rates that adjust periodically. The adjustments are based on changes in a reference interest rate or index. Unlike fixed-rate notes, which pay a constant interest rate over the life of the note, variable rate notes offer interest payments that can increase or decrease in line with the benchmark rate.

How do variable rate notes work?

Variable rate notes work by linking the interest payments to a benchmark rate. The key components of a VRN include:

• Benchmark rate: The interest rate is tied to a reference rate such as the London Interbank Offered Rate (LIBOR), the U.S. Treasury bill rate, or the prime rate.
• Spread: The issuer may add a fixed percentage (spread) to the benchmark rate to determine the total interest rate paid to investors.
• Reset period: The interest rate is adjusted at regular intervals, such as monthly, quarterly, or semi-annually, based on changes in the benchmark rate.

Example:

A variable rate note might have an interest rate set at LIBOR plus 2%. If LIBOR is 1.5%, the interest rate for the note would be 3.5%. If LIBOR rises to 2.5% at the next reset period, the new interest rate would be 4.5%.

Importance of variable rate notes

Variable rate notes are important for both issuers and investors:

• For issuers: VRNs allow issuers to potentially benefit from lower initial interest rates and to align their interest expenses more closely with prevailing market rates.
• For investors: VRNs provide protection against rising interest rates, as the interest payments adjust upward with increases in the benchmark rate, helping to preserve the real value of the investment.

Impact of variable rate notes on the financial market

Positive impacts

• Interest rate risk management: VRNs help both issuers and investors manage interest rate risk by aligning interest payments with current market rates.
• Attractive investment option: For investors seeking protection against inflation and rising interest rates, VRNs offer a variable income stream that adjusts with market conditions.
• Funding flexibility: Issuers, including corporations and municipalities, use VRNs as a flexible funding tool that can adapt to changing interest rate environments.

Negative impacts

• Interest rate volatility: VRNs expose investors to interest rate volatility, as payments can decrease if the benchmark rate falls.
• Complexity: The terms and mechanisms of VRNs can be complex, requiring investors to understand the underlying benchmark rates and reset periods.

Example:

A municipality issues a variable rate note with an interest rate linked to the U.S. Treasury bill rate plus 1%. During periods of rising interest rates, the municipality’s interest payments will increase, affecting its budget. Conversely, during periods of falling rates, the payments will decrease, providing budget relief.

Challenges and considerations in managing variable rate notes

• Market fluctuations: Investors need to monitor market conditions and benchmark rates to understand potential changes in their interest income.
• Credit risk: Like all debt instruments, VRNs carry credit risk, where the issuer may default on interest or principal payments.
• Liquidity: The liquidity of VRNs can vary, and investors should consider the ease of buying or selling these notes in the secondary market.

Example:

An investor purchases a corporate variable rate note with interest payments tied to the prime rate. If the prime rate increases, the investor benefits from higher interest payments. However, if the corporation faces financial difficulties, the investor may face credit risk.

Understanding variable rate notes is essential for managing interest rate risk and making informed investment decisions. For further exploration, related topics include fixed rate bonds, interest rate risk, benchmark rates, and bond market dynamics. These subjects provide deeper insights into the mechanisms and implications of variable rate notes in financial markets.