Floating Rate Bond.doc

Published on July 2016 | Categories: Types, School Work | Downloads: 32 | Comments: 0 | Views: 196
of 3
Download PDF   Embed   Report

A floating-rate security, also known as a “floater”, is an investment with interest payments that float or adjust periodically based upon a predetermined benchmark. While floaters may be linked to almost any benchmark and pay interest based on a variety of formulas, the most basic type pays a coupon equal to some widely followed interest rate or a change in a given index over a defined time period, such as the year-over-year change in the Consumer Price Index (CPI), plus a fixed spread in basis points (1bp = 1/100 of 1% or .01%). Only this type of floater will be discussed here.

Comments

Content


A Guide to Understanding Floating-Rate Securities
A foating-rate security, also known as a “foater”, is an investment with
interest payments that foat or adjust periodically based upon a
predetermined benchmark. While foaters may be linked to almost any
benchmark and pay interest based on a variety o ormulas, the most basic
type pays a coupon e!ual to some widely ollowed interest rate or a change in
a given inde" over a de#ned time period, such as the year-over-year change
in the $onsumer %rice &nde" '$%&(, plus a #"ed spread in basis points ')bp *
)+),, o )- or .,)-(. .nly this type o foater will be discussed here.
Who Invests in Floaters
&nvestors who believe that interest rates and+or infation may rise and are
dissatis#ed with low short-term rates may consider a foating-rate investment.
Who Issues Floaters
/oth 0overnment-1ponsored 2nterprises '012s( and corporations issue
foaters as part o their overall unding strategy.
How are Floaters Structured
Apart rom the credit-worthiness rom the issuer, the important determinant o
a foater3s perormance is the underlying benchmark or the reerence rate,
such as year over year change in the $%& '$onsumer %rice &nde"(. An e"ample
o this coupon structure might read4 5onthly reset, - change in $%& 6 )7,bp.
.ther foating rate securities are based on the 8-month 9ondon &nterbank
.:er ;ate '8-month 9&/.;(, which currently stands at ,.7<-. An e"ample
spread or this type o security might read4 =uarterly ;eset, 8-month 9&/.;
6),,bp. ;eerence rates typically used as benchmarks include >.1. ?reasury
/ills '?-bills(, the 9ondon &nterbank .:ered ;ate '9&/.;(, the %rime ;ate,
another short-term interest rate or $%& '$onsumer %rice &nde"(. .nce the
benchmark is chosen, the issuer will establish an additional “spread” that it is
willing to pay in e"cess o the reerence rate. ?his spread is generally
e"pressed in basis points 'a basis point is one one-hundredth o one percent
or .,)-(, and is added to the reerence rate to determine the overall coupon.
@or e"ample, a foater may be issued with a spread o A, basis points above
the three-month ?-bill rate. & the ?-bill rate is B.,,- on the day the foater is
issued, its initial coupon will be B.A,- 'B.,,- 6 ,.A,- * B.A,-(. ?he spread
or any particular foater will be based on a variety o actors including the
credit !uality o the issuer and the time to maturity. &t is important to note
that since short-term rates are usually lower than long-term rates, the initial
coupon o a foater is typically lower than that o a #"ed-rate note o the same
maturity.
.ther foating rate securities are based on the 8-month 9ondon &nterbank
.:er ;ate '8-month 9&/.;(, which currently stands at ,.7<-. An e"ample
spread or this type o security might read4 =uarterly ;eset, 8-month 9&/.;
6),,bp.
Another important component o a foater3s structure is the reset re!uency C
how oten the interest rate is adjusted to refect the current reerence rate. A
foater3s coupon can reset as oten as daily or as inre!uently as once per
year. &t is !uite common or the coupon to reset each time an interest
payment is made, and then remain constant until the ne"t coupon payment
date. & the foater resets more re!uently than interest is paid, the coupon
payment will generally refect the average o each reset since the previous
interest payment. @or e"ample, a monthly reset+!uarterly pay foater3s
interest payment would refect the average o the three monthly resets that
occurred in the previous !uarter.
A foater may be issued as either non-callable or callable. & issued as callable,
the call is at the option o the issuer, giving the issuer an opportunity to pay
the principal to the holders and stop making payments. @loaters have a
variety o maturities, although most are issued with maturities o ), years or
less.
Understanding Caps and Floors
5any foaters are issued with a “cap”, a “foor,” or both. A cap is the
ma"imum interest rate the issuer will pay regardless o how high the
reerence rate may go, and thereore protects the issuer rom escalating
interest costs. $onversely, a foor sets the minimum rate that will be paid
even i the coupon determined by the reerence rate were lower, and protects
the investor rom declining income. ?he ollowing table illustrates the
di:erence between two foaters that pay a spread o A, basis points above
the reerence rateD one with a A- cap and B- foor, and one without a cap or
foor4
;e. ;ate With $ap+@loor Eo $ap+@loor
).,,-B.,,-).A,-
B.,,-B.A,-B.A,-
8.,,-8.A,-8.A,-
A.,,-A.,,-A.A,-
Benefts o Investing in Floaters
/ene#t rom ;ising &nterest ;ates
&nvestors are sometimes reluctant to “lock-in” a current #"ed rate or the long
term because they believe rates will rise in the uture. Fowever, rates
available on short-term investments may be lower than the investor is willing
to accept. @loaters o:er an alternative which pays a spread above current
short-term rates and also enjoys the bene#t o uture rate increases.
!i"ited #rice Sensitivit$ to Interest Rates
@i"ed-rate bonds tend to decrease in value when interest rates rise and
increase in value when rates all. ?he bond3s value changes to compensate or
the di:erence between its #"ed coupon rate and current interest rates.
/ecause a foater3s coupon rate changes when market rates change, its price
will normally fuctuate less than #"ed-rate bonds o similar maturity. Fowever,
there is no assurance that coupon changes will refect the current level o
interest rates.
Secondar$ %ar&et
@loaters are most suitable or purchasing and holding to maturity. Fowever,
investors may #nd it necessary to sell their foating-rate investment prior to
maturity. @loaters may be traded in the secondary market, which provides an
opportunity or investors to sell them at then prevailing market levels, which
may be more or less than the purchase price. Although not obligated to do so,
;aymond Games and other broker+dealers may maintain a secondary market
in foating rate securities. Fowever, there is no assurance that an active
market will develop or be maintained.
Invest"ent Considerations
Reerence Rate Ris&
While the market value o a foater under normal circumstances is relatively
insensitive to changes in interest rates, the income received is, o course,
highly dependent upon the level o the reerence rate over the lie o the
investment. ?otal return may be less than anticipated i uture interest rate or
reerence rate e"pectations are not met.
Credit Ris&
As with any #"ed income investment, there is a risk that the issuer will be
unable to meet its payment obligations. $hanges in the creditworthiness o
the issuer 'whether or not refected in changes to the issuerHs rating( can
decrease or increase the current market value and may result in a partial or
total loss o your investment. 1ecurities ratings provided by independent
nationally recogniIed statistical organiIations, also called ;atings Agencies,
are appraisals o the #nancial stability o a particular issuer and its ability to
pay income and return principal on your investment. Although they can assist
investors in evaluating the creditworthiness o an issuer, ratings are not
recommendations to buy, sell or hold a security nor do ratings remove market
risk. &n addition, ratings are subject to review, revision, suspension, reduction
or withdrawal at any time, and any o these changes in ratings may a:ect the
current market value o your investment.
Call Ris&
& a callable foater is called by the issuer prior to maturity, the investor may
be unable to reinvest unds in another foater with comparable terms. & the
foater is not called, the investor should be prepared to hold it until maturity.

Sponsor Documents

Or use your account on DocShare.tips

Hide

Forgot your password?

Or register your new account on DocShare.tips

Hide

Lost your password? Please enter your email address. You will receive a link to create a new password.

Back to log-in

Close