Definition of Capped Floating-Rate Note (Capped FRN)
A Capped Floating-Rate Note (Capped FRN) is a type of debt security that accrues interest based on a floating or variable rate benchmark, such as the London Interbank Offered Rate (LIBOR), but with a cap on how high the interest rate can rise. This characteristic limits the maximum interest the issuer is obligated to pay, offering a cushion against climbing interest rates.
Examples of Capped Floating-Rate Note (Capped FRN)
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Corporate Capped FRN: A corporation issues a capped FRN with a variable interest rate set at LIBOR + 2%, but with an interest cap at 5%. If the LIBOR rises, the interest payment increases to accommodate the new rate until it hits the 5% cap.
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Sovereign Capped FRN: A government issues a capped FRN to manage its debt servicing costs better in a volatile interest rate environment. For instance, the capped FRN might follow the yield on 10-year government bonds with a cap that ensures interest payments do not exceed a predetermined rate, say 6%.
Frequently Asked Questions (FAQs)
1. How does a Capped FRN differ from a traditional FRN?
A capped FRN includes an upper limit or cap on the interest rate, whereas a traditional FRN has no such limit and can increase indefinitely with market rates.
2. Why would an investor choose a capped FRN?
Investors might choose capped FRNs to benefit from potentially higher returns associated with floating rates while reducing the risk of interest rates skyrocketing beyond a comfortable level.
3. How does the cap affect the yield on a capped FRN?
The cap typically limits the maximum yield to protect the issuer, potentially making capped FRNs yield lower compared to uncapped FRNs in environments with rising interest rates.
4. Are there disadvantages to investing in capped FRNs?
One downside is the potential for lower returns if interest rates exceed the cap, preventing the holder from benefiting from the full measure of rising rates.
5. Who issues capped FRNs?
Both corporate entities and government agencies can issue capped FRNs to manage their debt effectively while giving investors an attractive investment instrument with controlled risk.
Related Terms
- Floating-Rate Note (FRN): A debt instrument with a variable interest rate that adjusts based on a benchmark, such as LIBOR or Treasury rates.
- Cap: The maximum interest rate limit set on a capped FRN to prevent uncontrolled interest expense.
- Benchmark Rate: The reference rate (e.g., LIBOR, Treasury yield) used for setting the floating interest rate on an FRN or capped FRN.
- Interest Rate Risk: The risk borrowers or investors face due to fluctuations in interest rates, which capped FRNs partially mitigate by capping the rate.
Online References to Online Resources
- Investopedia - Floating Rate Note
- Financial Times Lexicon - Capped Floating Rate Note
- SIFMA - Floating Rate Notes
Suggested Books for Further Studies
- “Fixed Income Securities: Tools for Today’s Markets” by Bruce Tuckman and Angel Serrat – Provides in-depth knowledge on various fixed income securities, including FRNs, and their applications.
- “Bond Markets, Analysis and Strategies” by Frank J. Fabozzi – A comprehensive resource that discusses bond market mechanics, with explanations on FRNs and capped FRNs.
- “The Handbook of Fixed Income Securities” by Frank J. Fabozzi – Offers extensive coverage on fixed income investments, including an analysis of the risks and advantages of floating-rate notes.
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