CHAPTER
SEVENTEEN
FLOATING-RATE SECURITIES
FRANK J. FABOZZI, PH.D., CFA, CPA
Professor of Finance
EDHEC Business School
STEVEN V. MANN, PH.D.
Professor of Finance
Moore School of Business
University of South Carolina
Under the rubric of floating-rate securities or simply floaters, there are several different types of securities with an essential feature in common: coupon interest will vary over the instrument’s life. Floaters, which were first introduced into the European debt market and issued in the United States in the early 1970s, are now issued in every sector of the bond market—government, agency, corporate, municipal, mortgage, and asset-backed—in the United States and in markets throughout the world. Although a floater’s coupon formula may depend on a wide variety of economic variables (e.g., foreign exchange rates or commodity prices), a floater’s coupon payments usually depend on the level of a money market interest rate (e.g., the London Interbank Offer Rate, or LIBOR, Treasury bills). A floater’s coupon rate can be reset semiannually, quarterly, monthly, or weekly. The term adjustable rate or variable rate typically refers to securities with coupon rates reset not more than annually or based on a longer-term interest rate. However, this is a distinction without a difference, and we will refer to both floating-rate securities and adjustable-rate securities as “floaters.”
In this chapter we will discuss the general features of floaters and present some illustrations of the major product types. Most market participants use “spread” or margin measures (e.g., adjusted simple margin or discount margin) to assess the relative value of a floater. We will briefly describe these measures and note their limitations. Finally, we discuss several popular portfolio strategies that employ floaters.
Parts of this chapter are adapted from Frank J. Fabozzi and Steven V. Mann, Floating-Rate Securities (New Hope, PA: Frank J. Fabozzi Associates, 2000).
GENERAL FEATURES OF FLOATERS AND MAJOR PRODUCT TYPES
A floater is a debt security whose coupon rate is reset at designated dates based on the value of some designated reference rate. The coupon formula for a pure floater (i.e., a floater with no embedded options) can be expressed as follows:
Coupon rate = reference rate ± quoted margin
The quoted margin is the adjustment (in basis points) that the issuer agrees to make to the reference rate. For example, consider a floating-rate note issued in September 2007 by Bank of America that matured on September 11, 2011. This floater delivered cash flows quarterly and had a coupon formula equal to three-month LIBOR plus 12 basis points.
As noted, the reference rate is the interest rate or index that appears in a floater’s coupon formula, and it is used to determine the coupon payment on each reset date within the boundaries designated by embedded caps and/or floors. The four most common reference rates are LIBOR, Treasury bill yields, prime rates, and domestic CD rates, and they appear in the coupon formulas of a wide variety of floating-rate products. Other reference rates are used in more specialized markets such as the markets for mortgage-backed securities and the municipal market. For example, the most common reference rates for adjustable-rate mortgages (ARMs) or collateralized mortgage obligation (CMO) floaters include (1) the one-year Constant Maturity Treasury Rate (i.e., one-year CMT), (2) the 11th District Cost of Funds (COFI), (3) the six-month LIBOR, and (4) the National Monthly Median Cost of Funds Index. In the municipal market, the reference rate for floaters is often a Treasury rate or the prime rate. Alternatively, the reference rate could be a municipal index. Three popular municipal indexes are the J. J. Kenney Index, the Bond Buyer 40 Bond Index, and the Merrill Lynch Municipal Securities Index.1
A floater often imposes limits on how much the coupon rate can float. Specifically, a floater may have a restriction on the maximum coupon rate that will be paid on any reset date. This is called a cap. Consider a floater issued by Federal Home Bank that matured on October 20, 2006. The coupon formula was three-month LIBOR plus 75 basis points with a cap of 3.75%. If the three-month LIBOR at a coupon date reset was 3.25%, then the coupon formula would suggest the new coupon rate would be 4%. However, the cap restricted the maximum coupon rate to 3.75%. Needless to say, a cap is an unattractive feature from the investor’s perspective.
In contrast, a floater also may specify a minimum coupon rate called a floor. Suppose a floater delivers quarterly coupon payments with a coupon formula of the three-month LIBOR plus 12.5 basis points with a floor of 4.25%. Thus, if the three-month LIBOR ever fell below 4.125%, the coupon rate would remain at 4.25%. A floor is an attractive feature from the investor’s perspective. When a floater possesses both a cap and a floor, this feature is referred to as a collar. Thus a collared floater’s coupon rate has a maximum and a minimum value.
While a floater’s coupon rate typically moves in the same direction as the reference rate, there are floaters whose coupon rate changes in the opposite direction from the change in the reference rate. These floaters are referred to as inverse floaters or reverse floaters. A general formula for an inverse floater is
K – L × (reference rate)
From the formula, it is easy to see that as the reference rate goes up (down), the coupon rate goes down (up). As an example, consider an inverse floater issued by a large bank. This issue delivered quarterly coupon payments according to the formula
18% – 2.5 × (three-month LIBOR)
In addition, this inverse floater has a floor of 3% and a cap of 15.5%. Note that for this inverse floater, the value for L (called the coupon leverage) in the coupon reset formula is 2.5. Assuming that neither the cap rate nor the floor rate are binding, this means that for every one basis point change in the three-month LIBOR, the coupon rate changes by 2.5 basis points in the opposite direction.2
There is a wide variety of floaters that have special features that may appeal to certain types of investors. For example, some issues provide for a change in the quoted margin (i.e., the spread added to or subtracted from the reference in the coupon reset formula) at certain intervals over a floater’s life. These issues are called stepped-spread floaters because the quoted margin can either step to a higher or lower level over time. Consider Abu Dhabi Commercial Bank’s floater due in May 2016. From its issuance in May 2006 until May 2011, the coupon formula was 3-month LIBOR plus 60 basis points. Thereafter, until maturity, the quote margin “steps up” to 90 basis points.
A range note is a floater where the coupon payment depends on the number of days that the specified reference rate stays within a preestablished collar. For instance, Barclay’s Bank issued a range note in November 2006 (due in November 2016). For every day during the quarter that the three-month LIBOR was between 3% and 9%, the investor earned the three-month LIBOR plus 155 basis points. Interest would accrue at 0% for each day that the three-month LIBOR was outside this collar.
There are also floaters whose coupon formula contains more than one reference rate. A dual-indexed floater is one such example. The coupon rate formula is typically a fixed percentage plus the difference between two reference rates. For example, Swedbank Hypotek issued a floater that matures in August 2015 whose coupon formula is the following:
20 year yen swap rate – 2 year yen swap rate + 40 basis points. In addition, the issue has a floor of 0.1%.
Although the reference rate for most floaters is an interest rate or an interest-rate index, numerous kinds of reference rates appear in coupon formulas. This is especially true for structured notes. Potential reference rates include movements in foreign exchange rates, the price of a commodity (e.g., gold), movements in an equity index (e.g., the Standard & Poor’s 500 Index), or an inflation index (e.g., CPI). Financial engineers are capable of structuring floaters with almost any reference rate. For example, in March 1996, the Federal Home Loan Bank issued a structured note with the seven-year swap rate as the reference rate in the coupon formula. Specifically, this inverse floater makes semiannual coupon payments using the following formula:
2.5 × (9.219% – 7-year swap rate)
This issue has a floor of 0%.
CALL AND PUT PROVISIONS
Just like fixed-rate issues, a floater may be callable. The call option gives the issuer the right to buy back the issue prior to the stated maturity date. The call option may have value to the issuer some time in the future for two basic reasons. First, market interest rates may fall so that the issuer can exercise the option to retire the floater and replace it with a fixed-rate issue. Second, the required margin decreases so that the issuer can call the issue and replace it with a floater with a lower quoted margin.3 The issuer’s call option is a disadvantage to the investor because the proceeds received must be reinvested either at a lower interest rate or a lower margin. Consequently, an issuer who wants to include a call feature when issuing a floater must compensate investors by offering a higher quoted margin.
For amortizing securities (e.g., mortgage-backed and some asset-backed securities) that are backed by loans that have a schedule of principal repayments, individual borrowers typically have the option to pay off all or part of their loan prior to the scheduled date. Any additional principal repayment above the scheduled amount is called a prepayment. The right of borrowers to prepay is called the prepayment option. Basically, the prepayment option is analogous to a call option. However, unlike a call option, there is not a call price that depends on when the borrower pays off the issue. Typically, the price at which a loan is prepaid is its par value.
Floaters also may include a put provision that gives the security holder the option to sell the security back to the issuer at a specified price on designated dates. The specified price is called the put price. The put’s structure can vary across issues. Some issues permit the holder to require the issuer to redeem the issue on any coupon payment date. Others allow the put to be exercised only when the coupon is adjusted. The time required for prior notification to the issuer or its agent varies from as little as four days to as long as a couple of months. The advantage of the put provision to the holder of the floater is that if after the issue date the margin required by the market for a floater to trade at par rises above the issue’s quoted margin, the investor can force the issuer to redeem the floater at the put price and then reinvest the proceeds in a floater with the higher quoted margin.
SPREAD MEASURES
There are several yield spread measures or margins that are used routinely to evaluate floaters. The four margins commonly used are spread for life, adjusted simple margin, adjusted total margin, and discount margin. All these spread measures are available on Bloomberg’s Yield Analysis (YA) screen.
Spread for Life
When a floater is selling at a premium/discount to par, a potential buyer of a floater will consider the premium or discount as an additional source of dollar return. Spread for life (also called simple margin) is a measure of potential return that accounts for the accretion (amortization) of the discount (premium) as well as the constant index spread over the security’s remaining life.
Adjusted Simple Margin
The adjusted simple margin (also called effective margin) is an adjustment to spread for life. This adjustment accounts for a one-time cost-of-carry effect when a floater is purchased with borrowed funds. Suppose that a security dealer has purchased $10 million of a particular floater. Naturally, the dealer has a number of alternative ways to finance the position—borrowing from a bank, repurchase agreement, etc. Regardless of the method selected, the dealer must make a onetime adjustment to the floater’s price to account for the cost of carry from the settlement date to next coupon reset date.
Adjusted Total Margin
The adjusted total margin (also called total adjusted margin) adds one additional refinement to the adjusted simple margin. Specifically, the adjusted total margin is the adjusted simple margin plus the interest earned by investing the difference between the floater’s par value and the carry-adjusted price.4
Discount Margin
One common method of measuring potential return that employs discounted cash flows is discount margin. This measure indicates the average spread or margin over the reference rate the investor can expect to earn over the security’s life given a particular assumed path that the reference rate will take to maturity. The assumption that the future levels of the reference rate are equal to today’s level is the current market convention. The procedure for calculating the discount margin is as follows:
1. Determine the cash flows assuming that the reference rate does not change over the security’s life.
2. Select a margin (i.e., a spread above the reference rate).
3. Discount the cash flows found in (1) by the current value of the reference rate plus the margin selected in (2).
4. Compare the present value of the cash flows as calculated in (3) with the price. If the present value is equal to the security’s price, the discount margin is the margin assumed in (2). If the present value is not equal to the security’s price, go back to (2) and select a different margin.
For a floater selling at par, the discount margin is simply the quoted margin. Similarly, if the floater is selling at a premium (discount), then the discount margin will be below (above) the quoted margin.
Practitioners use the spread measures presented above to gauge the potential return from holding a floater. Much like conventional yield measures for fixed income securities, the yield or margin measures discussed here are, for the most part, relatively easy to calculate and interpret. However, these measures reflect relative value only under several simplifying assumptions (e.g., reference rates do not change).
One of the key difficulties in using the measures described in this chapter is that they do not recognize the presence of embedded options. As discussed, there are callable/putable floaters and floaters with caps and/or floors. However, the recognition of embedded options is critical to valuing floaters properly. If an issuer can call an issue when presented with the opportunity and refund at a lower spread, the investor must then reinvest at the lower spread. With this background, it should not be surprising that sophisticated practitioners value floaters using arbitrage-free binomial interest rate trees and Monte Carlo simulations. These models are designed to value securities whose cash flows are interest-rate-dependent.
PRICE VOLATILITY CHARACTERISTICS OF FLOATERS
The change in the price of a fixed-rate security when market rates change occurs because the security’s coupon rate differs from the prevailing rate for new comparable bonds issued at par. Thus an investor in a 10-year, 7% coupon bond purchased at par, for example, will find that the bond’s price will decline below par if the market requires a yield greater than 7% for bonds with the same risk and maturity. By contrast, a floater’s coupon resets periodically, thereby reducing its sensitivity to changes in rates. For this reason, floaters are said to be more “defensive” securities. This does not mean, of course, that a floater’s price will not change.
Factors That Affect a Floater’s Price
A floater’s price will change depending on the following factors:
1. Time remaining to the next coupon reset date
2. Changes in the market’s required margin
3. Whether or not the cap or floor is reached
We will discuss the impact of each of these factors in the following sections.
Time Remaining to the Next Coupon Reset Date
The longer the time to the next coupon reset date, the more a floater behaves like a fixed-rate security, and the greater is a floater’s potential price fluctuation. Conversely, the shorter the time between coupon reset dates, the smaller is the floater’s potential price fluctuation.
To understand why this is so, consider a floater with five years remaining to maturity whose coupon formula is the one-year Treasury rate plus 50 basis points, and the coupon is reset today when the one-year Treasury rate is 5.5%. The coupon rate will remain at 6% for the year. One month hence, an investor in this floater effectively would own an 11-month instrument with a 6% coupon. Suppose that at that time the market requires a 6.2% yield on comparable issues with 11 months to maturity. Then our floater would be offering a below-market rate (6% versus 6.2%). The floater’s price must decline below par to compensate the investor for the submarket yield. Similarly, if the yield that the market requires on a comparable instrument with a maturity of 11 months is less than 6%, the floater will trade at a premium. For a floater in which the cap is not binding and for which the market does not demand a margin different from the quoted margin, a floater that resets daily will trade at par.
Changes in the Market’s Required Margin
At the initial offering of a floater, the issuer will set the quoted margin based on market conditions so that the security will trade near par. Subsequently, if the market requires a higher/lower margin, the floater’s price will decrease/increase to reflect the current margin required. We shall refer to the margin that is demanded by the market as the “required margin.” For example, consider a floater whose coupon formula is the one-month LIBOR plus 40 basis points. If market conditions change such that the required margin increases to 50 basis points, this floater would be offering a below-market margin. As a result, the floater’s price will decline below par value. By the same token, the floater will trade above its par value if the required margin is less than the quoted margin—less than 40 basis points in our example.
The required margin for a particular issue depends on (1) the margin available in competitive funding markets, (2) the credit quality of the issue, (3) the presence of any embedded call or put options, and (4) the liquidity of the issue. An alternative source of funding to floaters is a syndicated loan. Consequently, the required margin will be driven, in part, by margins available in the syndicated loan market.
The portion of the required margin attributable to credit quality is referred to as the “credit spread.” The risk that there will be an increase in the credit spread required by the market is called credit-spread risk. The concern for credit-spread risk applies not only to an individual issue but also to a sector or the economy as a whole. For example, credit spreads may increase due to a financial crisis (e.g., a stock market crash) while the individual issuer’s condition and prospects remain essentially unchanged.
A portion of the required margin reflects the call risk if the floater is callable. Because the call feature imposes hazards on the investor, the greater the call risk, the higher is the quoted margin at issuance, other things equal. After issuance, depending on how interest rates and required margins change, the perceived call risk and the margin required as compensation for this risk will change accordingly. In contrast to call risk owing to an embedded call option, a put provision provides benefits to the investor. If a floater is putable at par, all else the same, its price should trade at par near the put date.
Finally, a portion of the quoted margin at issuance will reflect the issue’s perceived liquidity. Liquidity risk is the threat of an increase in the required margin due to a perceived deterioration in an issue’s liquidity. Investors in nontraditional floater products are particularly concerned with liquidity risk.
Whether or Not the Cap or Floor Is Reached
For a floater with a cap, once the coupon rate as specified by the coupon formula rises above the cap rate, the floater then offers a below-market coupon rate, and the floater will trade at a discount. The floater will trade more and more like a fixed-rate security the further the capped rate is below the prevailing market rate. Simply put, if a floater’s coupon rate does not float, it is effectively a fixed-rate security. Cap risk is the risk that the floater’s value will decline because the cap is reached.
The situation is reversed if the floater has a floor. Once the floor is reached, all else equal, the floater will trade either at par value or at a premium to par if the coupon rate is above the prevailing rate offered for comparable issues.
Duration of Floaters
We have just described how a floater’s price will respond to a change in the required margin, holding all other factors constant. As explained in Chapter 7, the measure used by market participants to quantify the sensitivity of a security’s price to changes in interest rates is called duration. A security’s duration tells us the approximate percentage change in its price for a 100 basis point change in rates. The procedure of computing a security’s duration was explained in Chapter 7.
Two measures are employed to estimate a floater’s sensitivity to each component of the coupon formula. Index duration is a measure of the floater’s price sensitivity to changes in the reference rates holding the quoted margin constant. Correspondingly, spread duration measures a floater’s price sensitivity to a change in the “quoted margin” or “spread” assuming the reference rate remains unchanged.
Price Volatility of an Inverse Floater
An inverse floater can be created by acquiring a fixed-rate security and splitting it into a floater and an inverse floater. The fixed-rate security from which the floater and inverse floater are created is called the collateral. The interest paid to the floater investor and inverse floater investor must be such that it is equal to the interest rate paid on the collateral.
Because valuations are additive (i.e., the value of the collateral is the sum of the floater and inverse floater values), durations (properly weighted) are additive as well. Accordingly, the duration of the inverse floater is related in a particular fashion to the duration of the collateral and the duration of the floater. Specifically, the duration of an inverse floater will be a multiple of the duration of the collateral from which it is created.
To understand this, suppose that a 30-year fixed-rate bond with a market value of $100 million is split into a floater and an inverse floater with market values of $80 million and $20 million, respectively. Assume also that the duration of the collateral (i.e., the 30-year fixed-rate bond) is 8. Given this information, we know that for a 100 basis point change in required yield the collateral’s value will change by approximately 8%, or $8 million (8% times $100 million). Since the floater and inverse floater are created from the collateral, the combined change in value of the floater and the inverse floater must be $8 million for a 100 basis point change in required yield. The question becomes how do we partition the change in value between the floater and inverse floater. If the duration of the floater is small, as explained earlier, then the inverse floater must experience the full force of the $8 million change in value. For this to occur, the duration of the inverse floater must be approximately 40. A duration of 40 will mean a 40% change in the inverse floater’s value for a 100 basis point change in required yield and a change in value of approximately $8 million (40% times $20 million).
Effectively, the inverse floater is a leveraged position in the collateral. That is, ownership of an inverse floater is equivalent to buying the collateral and funding it on a floating-rate basis, where the reference rate for the borrowing is equal to the reference rate for the inverse floater. Accordingly, the duration of the inverse floater is a multiple of the duration of the collateral.
PORTFOLIO STRATEGIES
Several portfolio strategies have been employed using floaters. These include (1) basic asset/liability management strategies, (2) risk arbitrage strategies, (3) betting on changes in the required margin, and (4) arbitrage between fixed-and floating-rate markets using asset swaps. We will briefly describe each of these strategies in turn.
Asset/liability management strategies can be explained most easily using depository institutions. These institutions typically borrow short term, and their objective is to lock in a spread over their short-term funding costs. Not surprisingly, one obvious way to accomplish this objective is to invest in floating-rate products. Naturally, this strategy is not without risks. The floater’s coupon rate likely will be capped, whereas the short-term funding may not be. This is known as cap risk. Further, the floater’s reference rate may not be the same as the reference rate for funding. If this is the case, the institution is exposed to basis risk.
Risk arbitrage strategies using floaters are not arbitrage in the true sense of the term. One example of this type of strategy involves money managers using leverage (via repurchase agreements) to invest in agency adjustable-rate passthrough securities that earn a higher spread over their borrowing rate. Of course, this is not a “risk free” transaction. Like before, the manager likely will be exposed to cap risk if the floater’s coupon is capped while the funding rate is not. The manager also may be exposed to basis risk if the two reference rates are mismatched. Finally, there is price risk if the floater’s risk changes for the worse, and the floater must be sold prior to maturity. In this case, the quoted margin will no longer compensate the investor for the security’s risks, and the floater will sell at a discount to par. No serious investor believes that a risk arbitrage strategy is a reliable source of spread income.
Investors also can speculate on whether a floater’s required margin will change. When a floater is issued, the quoted margin contained in the coupon formula will be set so that the floater will be priced at or near par. After the floater enters the secondary market, the quoted margin for a standard floater does not change. Thus, if the floater’s risk does not change and the compensation demanded by the market does not change either, the floater’s price will be par on every coupon reset date. In this case, the quoted margin offered by the security and quoted margin required by the market (called the required margin) are the same. If conditions change such that the required spread is greater than (less than) the quoted margin, the floater will trade at discount (premium) to par. Given this background, one obvious strategy money managers pursue is betting on a change in the required margin for a single issue or a sector.
Lastly, some money managers arbitrage between floaters and fixed-rate securities using a so-called asset swap. An asset-based swap transaction involves the creation of synthetic security via the purchase of an existing security and the simultaneous execution of a swap.
KEY POINTS
• A floater is a debt security whose coupon rate is reset at designated dates based on the value of some designated reference rate. The coupon formula for a floater with no embedded options is the reference rate plus or minus the quoted margin.
• Typically a floater imposes a cap or maximum interest coupon rate; a floater also may specify a floor or minimum coupon. A collared floater has both a cap and a floor.
• Inverse floaters or reverse floaters are floaters whose coupon rate moves in the opposite direction from the change in the reference rate.
• The different types of floaters include stepped-spread floaters, range notes, and dual-indexed floaters. Although the reference rate for most floaters is an interest rate or an interest rate index, numerous kinds of reference rates appear in coupon formulas.
• A floater may be callable or prepayment. Floaters also may include a put provision.
• Yield spread measures or margins that are commonly used routinely to evaluate floaters are spread for life, adjusted simple margin, adjusted total margin, and discount margin.
• The price of a floater depends on (1) the time remaining to the next coupon reset date, (2) changes in the market’s required margin, and (3) whether or not the cap or floor is reached.
• Index duration is a measure of the floater’s price sensitivity to changes in the reference rates holding the quoted margin constant. Spread duration measures a floater’s price sensitivity to a change in the “quoted margin” or “spread” assuming the reference rate remains unchanged.
• An inverse floater is effectively a leveraged position in the collateral because the position is economically equivalent to buying the collateral and funding it on a floating-rate basis, where the reference rate for the borrowing is equal to the reference rate for the inverse floater.
• The duration of an inverse floater is a multiple of the duration of the collateral.
• Portfolio strategies using floaters include (1) basic asset/liability management strategies, (2) risk arbitrage strategies, (3) betting on changes in the required margin, and (4) arbitrage between fixed- and floating-rate markets using asset swaps.