Floating coupon bonds are also known as floating rate notes, RNs, or Simply Floaters.

Unlike fixed coupon bonds, the interest rate on these bonds varies over time.

However, while the coupon rate itself changes, the coupon formula is set at bond issuance and it remains unchanged throughout the bond's life.

The coupon formula typically references a money market.

Benchmark rates such as IOR Interbank offered rates or the newer risk-free rates, RF arms plus or minus a spread.

Since the actual coupons depend on future developments of the reference rates, they cannot be known in advance.

So let's explore how these floating coupons work in practice and how eyeball linked floating rate notes differ from RFR linked floating rate notes.

Let's first consider a floating rate note linked to Euro or a common interbank offered rate in Europe.

Imagine an investor buys a 10 year floating rate note that pays six month euro or plus half a percent with semi-annual payments.

If the initial durable rate is fixed at 3.96%, the first coupon would be 4.46%, 3.96%, plus the half a percent spread.

Since the coupon is paid semi-annually, meaning the interest is paid for only half a year, the actual payment would be half of the 4.46% for that six month period.

Ignoring day count convention for simplicity.

As durable changes over the bond's life, the coupon for each subsequent period will vary accordingly.

If UBO rises in the next six months, the future coupon will increase.

If UBO declines, the future coupon will decrease.

But crucially, with eyeball links, floating rate notes, the exact coupon amount is always known at the beginning of the coupon period since the reference rates in this case is set in advance.

Now let's move on to floating rate notes linked to risk-free rates.

Frs like fra, the secured overnight financing rates, FRS are overnight rates, meaning they are backward looking and based on actual transactions.

This makes them quite different from the forward looking eyeball rates.

With RFR linked Floating rate notes, The reference rate resets daily, but for practical purposes, the coupon payments are usually made quarterly or at another regular interval.

So while the coupon resets daily based on software, the bond holder does not receive daily payments, but instead receives single interest payment at the end of the quarter.

Great. So let's look at an example.

Imagine the same 10 year floating rate notes that pays FRA plus half a percent with quarterly payments. This time when the bond is issued, the FRA fixing for the issue date won't be known until the next business day.

And since software is reset daily, the exact coupon payments won't be known until the end of the coupon period at the end of the quarter when the last software fixing has been published.

This is why we refer to these rates as backward looking, but how exactly are software links? Coupons calculated? Well in risk-free rate links, floating rate notes such as software, the coupon payments is often calculated using daily compounding.

This method accounts for the fact that the interest owed is accumulating daily, but not paid until the end of the coupon period.

In essence, the borrower is being charged interest not only on the principle that they've borrowed, but also on the accumulated unpaid interest.

The coupon payments is then calculated based on this compounded interest over the entire period.