Guide

Floating-rate notes (FRNs) explained

Harbor Capital's fixed-income sleeve held a ladder of five-year investment-grade corporates bought in 2021 when the ten-year Treasury yielded 1.5%. Over the next eighteen months the Federal Reserve lifted policy rates by 425 basis points. The fixed ladder lost roughly 12% on a mark-to-market basis while coupons stayed frozen at 3.2% — investors felt the pain of duration without immediate income relief. A parallel sleeve of three-month floating-rate notes reset coupons every quarter; income rose with SOFR, and prices stayed near par because the next payment already priced in higher short rates.

Floating-rate notes (FRNs) are debt securities whose coupon adjusts periodically to a benchmark rate plus a fixed spread. They trade near par when short rates move because principal value and coupon cash flows reprice together — the classic hedge when you expect rates to rise but do not want to sit in cash. This guide covers reset mechanics and benchmarks, quoted margin versus discount margin, duration and spread risk, caps and floors, Treasury versus corporate floaters, fund and ladder construction, the Harbor Capital refactor, a technique decision table, pitfalls, and an investor checklist.

How FRN coupons reset

Unlike a fixed-coupon bond, an FRN pays a coupon that changes on each reset date according to a formula in the indenture:

Coupon = Reference rate + Quoted margin (± any cap/floor adjustment)

Typical reset frequencies are monthly, quarterly, or semi-annually. The reference rate is observed on a specified lookback date (often two business days before reset) and applied to the outstanding principal. New-issue corporates and sovereign floaters today overwhelmingly reference SOFR (Secured Overnight Financing Rate) or compounded SOFR in arrears; older issues may still reference legacy LIBOR until they mature or convert via fallback language.

The quoted margin (also called the spread or coupon spread) is fixed at issuance — e.g. SOFR + 85 basis points. It compensates investors for credit risk and liquidity relative to risk-free floaters. Because the coupon floats, FRN prices tend to cluster near par (100) unless credit spreads widen or the issue trades at a discount margin different from the quoted margin.

Benchmark rates: SOFR, T-bills, and legacy LIBOR

Benchmark	Typical use	Reset behavior
SOFR (overnight or term/compounded)	U.S. corporate and agency FRNs post-LIBOR transition	Tracks secured overnight funding; compounded in arrears for many new issues
3-month Treasury bill rate	U.S. Treasury floating-rate notes (FRNs issued by Treasury)	Weekly auction high rate; resets quarterly on bill yield
€STR / SONIA / TONAR	Euro, UK, Japan sovereign and corporate floaters	Regional overnight risk-free replacements for EUR/GBP/JPY LIBOR
Legacy LIBOR (phasing out)	Older corporates and CLO tranches	Fallback triggers convert to SOFR + adjustment spread per ISDA protocol

U.S. Treasury FRNs are among the most liquid floaters globally: they reference the highest accepted discount rate at the weekly 13-week T-bill auction and pay quarterly. Investment-grade corporates typically pay SOFR + 60–150 bps depending on rating and tenor. Understanding which benchmark your holding uses matters for hedging — SOFR and fed funds move together but are not identical, and T-bill auctions can briefly diverge from overnight repo during stress.

Quoted margin vs discount margin

At issuance, investors buy at or near par and receive reference + quoted margin. In secondary trading, the market prices the bond at a discount margin (DM) — the spread above the forward curve of reference rates that equates projected floating coupons plus principal to the current dirty price.

Quoted margin — contractual spread in the indenture; unchanged for life of the bond.
Discount margin — market-implied spread given today's price; rises when credit weakens or liquidity dries up.
DM > quoted margin — bond trades at a discount to par; market demands extra spread for credit or liquidity.
DM < quoted margin — bond trades at a premium; rare unless credit improved or issue is scarce.

Unlike yield to maturity on fixed bonds, FRN yield metrics emphasize DM or yield to maturity on a floating basis assuming the forward curve realizes. When the Fed is hiking, a corporate FRN bought at DM = quoted margin + 20 bps still benefits from rising coupons while a fixed bond at the same issuer must rely on price depreciation to lift yield.

Duration, convexity, and what still moves

FRNs have very low effective duration to parallel shifts in the reference rate curve because the next coupon reset absorbs much of the rate change. That is why they outperform fixed-rate bonds in rising-rate environments. They are not duration-zero, however:

Reset lag — quarterly resets mean up to three months of stale coupon if rates jump intra-period.
Credit spread duration — if issuer credit deteriorates, DM widens and price falls like any corporate bond.
Caps and floors — a cap on the coupon reintroduces rate sensitivity when reference rates pierce the cap.
Liquidity premium — off-the-run corporates can gap on spread even when SOFR is flat.

In falling-rate cycles, FRNs underperform fixed coupons: your income steps down each reset while fixed bonds enjoy price appreciation. Callable fixed corporates add another asymmetry — see callable bonds for negative convexity when issuers refinance.

Caps, floors, and structured floaters

Some FRNs embed option-like features that change payoff profiles:

Feature	Effect on investor	When it matters
Cap (maximum coupon)	Income stops rising above cap even if SOFR soars	High-rate regimes; cap turns floater into pseudo-fixed at the top
Floor (minimum coupon)	Income cannot fall below floor when rates collapse	Issuer-friendly in ZIRP; investor pays premium for floor via lower quoted margin
Inverse floater	Coupon decreases when reference rate rises	Structured products; extreme rate risk — not a cash substitute
Step-up coupon	Spread increases if rating downgraded	Credit protection; rare in IG, more common in leveraged loans

Always read the indenture for lookback conventions (in advance vs in arrears), business-day adjustments, and fallback triggers if the benchmark is discontinued.

Harbor Capital cash-sleeve refactor

After the 2022–2023 rate shock, Harbor Capital rebalanced its liquidity bucket: 40% U.S. Treasury FRNs, 35% short corporate SOFR floaters (A-rated minimum), 15% government money market funds, 10% T-bills for settlement flexibility. The goal was positive real yield on cash with minimal NAV volatility — not to maximize spread like a high-yield sleeve.

Implementation rules they documented internally:

Buy corporates only at DM ≤ quoted margin + 25 bps unless credit research upgrades outlook.
Ladder reset dates monthly so the portfolio never has 100% coupons resetting same week.
Cap single-issuer exposure at 3% of the sleeve; prefer issuers with active SOFR floater programs for liquidity.
When the forward curve prices more than 100 bps of cuts within twelve months, trim corporates and add Treasury FRNs.
Track DM weekly; widen stop at +50 bps DM from purchase for IG names without fundamental change.

The refactor did not eliminate risk: one regional bank floater widened 180 bps on contagion fears even as SOFR rose. The lesson — floaters hedge rate risk, not credit risk.

Technique decision table

Goal	Prefer FRNs when…	Prefer alternative when…
Hedge rising policy rates	You need income that resets within months; can hold to reset dates	You expect aggressive cuts — fixed premium bonds may outperform
Cash parking with yield	Treasury FRNs or IG corporates near par, DM near quoted margin	Overnight liquidity is paramount — T-bills or MMFs settle T+0/T+1
Inflation protection	Not primary tool — coupons track nominal short rates	Real return matters — use TIPS or breakevens analysis
Maximum spread income	Leveraged loan ETFs and CLO debt are floating but carry credit beta	HY fixed at wide spread may beat floaters if defaults stay low
Predictable cash flows for liabilities	FRNs match floating-rate debt hedges (e.g. revolvers priced off SOFR)	Fixed pension outflows need LDI with duration-matched fixed bonds

Common pitfalls

Assuming FRNs are “cash” — corporate floaters can draw down 5–15% on spread widening.
Ignoring reset lag — sudden rate spikes do not lift income until the next reset date.
Comparing FRN yield to fixed YTM — use discount margin versus peers, not headline coupon alone.
LIBOR legacy without fallback review — confirm post-transition benchmark and adjustment spread.
Capped floaters in hiking cycles — income hits ceiling while uncapped alternatives keep rising.
Fund label confusion — “ultra-short bond” funds may hold fixed paper with more duration than FRN ETFs.
Tax oversight on Treasury FRNs — state tax treatment varies; some munis offer alternative for high-tax investors.
Overconcentration in one issuer's floater program — liquidity vanishes when the issuer stops tapping the market.

Investor checklist

Identify reference rate, reset frequency, and lookback convention in the indenture.
Record quoted margin at purchase; monitor discount margin in secondary.
Stress-test DM widening (+50 bps, +100 bps) against portfolio liquidity needs.
Map reset calendar across holdings to avoid synchronized income gaps.
Confirm LIBOR fallback or SOFR compounded settings for older issues.
Check for caps/floors that reintroduce duration or income floors.
Compare after-tax yield to T-bills and MMFs for cash-sleeve decisions.
Pair with fixed-duration bonds when liability horizon is multi-year and rates may fall.
Document credit rationale separately from rate view — floaters hedge only the latter.
Rebalance when forward curve implies material policy easing and DM is tight.

Key takeaways

FRN coupons reset to reference rate plus quoted margin — income rises when short rates rise.
Prices stay near par in rate shocks because cash flows reprice at the next reset.
Discount margin is the market spread; credit and liquidity still move the price.
They hedge rate risk, not credit risk — corporates can still sell off on spread.
In falling-rate regimes, fixed coupons typically outperform floaters on total return.