What is a Capped Floating Rate Note?

byMunyaradzi Mafaro published on

A capped floating rate note is a kind of investment. It is also called a “FRN” for short. FRNs are a type of bond. Bonds are when you loan money to a company or government. They agree to pay you back later and also pay you interest. The interest is called the “coupon”.

How Floating Rate Notes Work

Most bonds pay a fixed coupon that never changes. But floating rate notes are different. The coupon for FRNs can go up or down. It “floats” along with market interest rates.

Here’s how it works. The FRN will pay a coupon that is a set amount higher than a benchmark rate. A common benchmark is LIBOR, which stands for the London Interbank Offered Rate. Let’s say the FRN pays 1% over LIBOR. If LIBOR is at 2%, the FRN pays a 3% coupon (because 2% + 1% = 3%). If LIBOR goes up to 3%, now the FRN pays 4%.

FRNs are good if you think interest rates will go up. You earn more money as rates rise. Regular bonds lose value if rates go up. So FRNs give you protection against rising rates.

The Cap on Capped Floating Rate Notes

Regular FRNs will keep paying higher coupons as rates increase. But capped FRNs are different. They put a limit on how high the coupon can go. This upper limit is called the “cap” or the “strike”.

Let’s go back to our example. The FRN pays 1% over LIBOR. But let’s say this FRN has a cap of 5%. Here’s what happens:

  • If LIBOR is 2%, the FRN pays 3% (2% + 1%). This is below the 5% cap, so no problem.
  • If LIBOR goes up to 3%, the FRN pays 4% (3% + 1%). Still below the 5% cap.
  • But what if LIBOR keeps rising to 6%? Normally, the FRN would pay 7% (6% + 1%). But 7% is above the 5% cap! So instead, the coupon gets “capped” at 5%. The investor doesn’t get the full benefit of rates rising above 5%.

Pros and Cons of Capped FRNs

Investors buy capped FRNs for a few reasons:

  1. They provide some protection if interest rates go up. You earn a higher coupon as rates rise.
  2. But they also limit your downside. You know the most you could lose. The cap puts a ceiling on your risk.
  3. Capped FRNs often pay higher coupons than regular bonds. Investors get paid extra for accepting the cap.

But there are also some drawbacks investors should know:

  1. You give up the chance to earn even higher returns if rates rise a lot. The cap limits your upside.
  2. Capped FRNs can be harder to sell than regular bonds. There may not be as many buyers.
  3. These notes can be complex. The floating coupons and caps can be confusing.

The Investor’s Maximum Return

When you buy a capped FRN, your profit is limited. You can only earn so much before you hit the cap. This maximum return is important to understand.

Let’s say you invest $1,000 into a 5-year capped FRN. It pays 2% over LIBOR and has a 6% cap. The most you could earn each year is 6%. Over 5 years, your total profit can’t be more than $300 (6% X $1,000 X 5 years).

You’re giving up the chance to earn an unlimited return. If rates spike to 10%, too bad. You still only get 6%. The cap puts a firm limit on how much money you can make. Investors accept this limit in exchange for the other benefits that capped FRNs offer.

Capped FRNs in a Portfolio

Investors often use capped FRNs as one part of a bigger portfolio. They can help in a few ways:

  1. Diversification. Capped FRNs are different from stocks and regular bonds. Owning different types of investments can lower risk.
  2. Income. The floating coupons can provide a steady stream of income, up to a point. This can be good for retirees or others who need to rely on investment income.
  3. Managing interest rate risk. If rates rise, regular bonds lose money. Capped FRNs can cushion some of that blow.

But investors have to be careful. They shouldn’t put all their money into capped FRNs. The caps do limit their return potential. And these notes can be illiquid and complex. As with any investment, it’s about balancing risk and reward.

Other Considerations

A few other things to know about capped floating rate notes:

  • Credit Risk: If the issuer has money problems, they may not be able to pay the coupons or principal. Look at the issuer’s credit rating.
  • Tax Treatment: The coupons from FRNs are usually taxed as ordinary income, not capital gains. This can mean a higher tax rate. Consult a tax advisor.
  • Liquidity: It may be hard to sell a capped FRN if you need the money. There may not be many buyers. You could have to sell for less than you paid.
  • Fees: Some FRNs, especially if bought through a broker, can have high fees. These eat into your returns. Look for low fees when possible.
Munyaradzi Mafaro

Munyaradzi Mafaro is a music enthusiast and he also likes to tackle topics of business, productivity, and the possibilities for growth in the digital world.