As someone who has spent years analyzing fixed-income securities, I find Floating Rate Notes (FRNs) fascinating. They offer a unique blend of flexibility and risk management, especially in volatile interest rate environments. Among FRNs, Perpetual FRNs stand out due to their lack of maturity date, making them both intriguing and complex. In this guide, I’ll break down everything you need to know about Perpetual FRNs—how they work, their valuation, risks, and why they matter in today’s financial landscape.
Table of Contents
What Are Floating Rate Notes (FRNs)?
Floating Rate Notes are debt instruments with variable coupon payments tied to a reference interest rate, such as LIBOR (soon to be replaced by SOFR), the Fed Funds Rate, or the Treasury Bill rate. Unlike fixed-rate bonds, where the coupon remains constant, FRNs adjust periodically, protecting investors from interest rate risk.
Key Features of FRNs
- Variable Coupons: Payments reset at predetermined intervals (e.g., quarterly, semi-annually).
- Reference Rate + Spread: The coupon formula is typically:
Coupon = Reference\ Rate + Fixed\ Spread - Liquidity: Often more liquid than fixed-rate bonds due to their appeal in rising-rate environments.
Introducing Perpetual FRNs
Perpetual FRNs are a subset of FRNs with no maturity date. Issuers pay coupons indefinitely unless they choose to call (redeem) the bond. These instruments are rare but serve specific purposes, such as bolstering bank capital (as seen with Additional Tier 1 (AT1) bonds).
Why Do Perpetual FRNs Exist?
- Capital Flexibility: Banks and corporations use them to meet regulatory capital requirements without diluting equity.
- Investor Appeal: In a rising-rate environment, investors get protection against inflation.
- Issuer Benefits: No principal repayment obligation eases long-term liability management.
How Perpetual FRNs Are Priced
Valuing a Perpetual FRN involves estimating the present value of an infinite stream of floating coupons. The formula resembles a perpetuity but with a twist—the coupons fluctuate.
Basic Valuation Model
The price (P) of a Perpetual FRN can be approximated as:
P = \frac{C}{(1 + r)^1} + \frac{C}{(1 + r)^2} + \frac{C}{(1 + r)^3} + \dots = \frac{C}{r}But since the coupon (C) changes with the reference rate, we adjust for the expected future rates.
Example Calculation
Suppose a Perpetual FRN pays SOFR + 2.5%, and SOFR is currently 3%. The initial coupon is:
Coupon = 3\% + 2.5\% = 5.5\%If the market requires a 6% yield for similar-risk instruments, the price would be:
P = \frac{5.5\%}{6\%} = 91.67\%\ of\ parThis discount reflects the lower coupon relative to market yields.
Risks of Perpetual FRNs
1. Interest Rate Risk (Limited but Present)
While FRNs mitigate rate risk compared to fixed bonds, Perpetual FRNs still face repricing risk if spreads widen.
2. Call Risk
Most Perpetual FRNs are callable. If rates fall, issuers may redeem them, forcing investors into lower-yielding alternatives.
3. Credit Risk
Since they lack maturity, investors bear issuer credit risk indefinitely.
4. Liquidity Risk
Perpetual FRNs trade less frequently, potentially leading to wider bid-ask spreads.
Comparing Perpetual FRNs to Other Instruments
| Feature | Perpetual FRN | Traditional FRN | Fixed-Rate Bond | Preferred Stock |
|---|---|---|---|---|
| Maturity | None | Yes | Yes | None |
| Coupon Type | Floating | Floating | Fixed | Fixed/Floating |
| Callable? | Usually | Sometimes | Sometimes | Often |
| Seniority | Subordinated | Senior/Subord | Senior | Junior to bonds |
Real-World Application: AT1 Bonds
After the 2008 financial crisis, regulators demanded banks hold more loss-absorbing capital. Perpetual FRNs, particularly Additional Tier 1 (AT1) bonds, became a key tool. These bonds:
- Have no maturity.
- Can be written off or converted to equity if the bank struggles.
- Pay floating coupons to attract investors.
Case Study: Credit Suisse AT1 Wipeout (2023)
When UBS acquired Credit Suisse, Swiss regulators controversially wrote off $17 billion in AT1 bonds while preserving equity value—highlighting the risks of Perpetual FRNs.
Should You Invest in Perpetual FRNs?
Pros:
- Inflation Hedge: Coupons rise with rates.
- Higher Yields: Often offer better returns than short-term FRNs.
- Diversification: Low correlation with fixed-rate bonds.
Cons:
- Complexity: Harder to value than vanilla bonds.
- Call Risk: Early redemption can disrupt income streams.
- Regulatory Uncertainty: Banking rules may change, impacting issuers.
Final Thoughts
Perpetual FRNs occupy a niche but important space in fixed income. They appeal to investors seeking yield without duration risk but require careful due diligence. If you’re considering them, assess the issuer’s creditworthiness, call provisions, and the broader rate environment.
