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Chapter 7. Floating Rate Bonds

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Fixed Income Securities
This chapter is in the book Fixed Income Securities
Chapter7FloatingRateBondsUnlike plain vanilla bonds, whose coupons remain fixed from issue until maturity,floatingratenotesandbonds,alsoreferredtoasfloaters,aredebtsecuritieswhosecouponsareresetperiodicallybasedonareferenceorbenchmarkrate.TypicallythecoupononsuchasecurityisdefinedasBenchmarkRate+QuotedMargin.Ifthebenchmarkrateisashort-termrate,say6-MLIBOR,werefertothebondasafloatingratebond.1However,ifthebenchmarkisalong-termrate,thebondisreferredtoasavariableoradjustableratebond.Forinstance,considerasecuritywhosecouponisspecifiedasfive-yearT-noterate+75basispoints.Inthiscase,thereferenceorbenchmarkrateistheyieldonafive-yearT-note,andconsequently,thebondisclassifiedasavariableratebond.Itshouldbenotedthatthequotedmarginneednotalwaysbepositive.Forinstance,afloatercanhaveacouponratespecifiedas6-MLIBOR–25bp.Usuallythequotedmarginremainsconstantforthelifeofthefloater.However,there are securities, known asstepped spread floaters, where the margin is reset atintervals.Inthecaseofsuchsecurities,themarginmaybeincreasedordecreased.CallandPutProvisionsinFloatingRateBondsFloatingratenotesoftencomewithcalland/orputoptions.Acalloptionmaybein-vokedbytheissuer ifthereferencerateweretodecline.In suchasituation,theis-suer can recall a floater and issue a fixed rate bond at the prevailing rate, which islowerbyassumption.Theothersituationinwhichafloatercanberecallediswhenthecurrentlyrequiredmarginforthesecurityislowerthanwhatwasspecifiedearlier.Insuchasituation,thefloatercanberecalledandreplacedwithasecuritycarryingalowerquotedmargin.Aswehaveseenearlierinthecaseoffixedcouponsecurities,thecalloptionworksagainsttheinvestors.Iftheyreceivetheprincipalprematurely,theyhavetoreinvestitineitherasecuritywithalowercoupon,orasecuritywithasmallerquotedmargin.Floaterscancomewithputoptions,whereintheholdercansurrenderthebondpriortomaturity.Ifratesriseinthemarket,andthefloaterisputable,theholdercanreturn the bond, recover the principal, and reinvest it in a bond carrying a highercoupon,orinafloaterwithahigherquotedmargin.1Byshort-term,wemeanitisforaperiodlessthanorequaltooneyear.https://doi.org/10.1515/9781547400669-007
© 2019 Walter de Gruyter GmbH, Berlin/Munich/Boston

Chapter7FloatingRateBondsUnlike plain vanilla bonds, whose coupons remain fixed from issue until maturity,floatingratenotesandbonds,alsoreferredtoasfloaters,aredebtsecuritieswhosecouponsareresetperiodicallybasedonareferenceorbenchmarkrate.TypicallythecoupononsuchasecurityisdefinedasBenchmarkRate+QuotedMargin.Ifthebenchmarkrateisashort-termrate,say6-MLIBOR,werefertothebondasafloatingratebond.1However,ifthebenchmarkisalong-termrate,thebondisreferredtoasavariableoradjustableratebond.Forinstance,considerasecuritywhosecouponisspecifiedasfive-yearT-noterate+75basispoints.Inthiscase,thereferenceorbenchmarkrateistheyieldonafive-yearT-note,andconsequently,thebondisclassifiedasavariableratebond.Itshouldbenotedthatthequotedmarginneednotalwaysbepositive.Forinstance,afloatercanhaveacouponratespecifiedas6-MLIBOR–25bp.Usuallythequotedmarginremainsconstantforthelifeofthefloater.However,there are securities, known asstepped spread floaters, where the margin is reset atintervals.Inthecaseofsuchsecurities,themarginmaybeincreasedordecreased.CallandPutProvisionsinFloatingRateBondsFloatingratenotesoftencomewithcalland/orputoptions.Acalloptionmaybein-vokedbytheissuer ifthereferencerateweretodecline.In suchasituation,theis-suer can recall a floater and issue a fixed rate bond at the prevailing rate, which islowerbyassumption.Theothersituationinwhichafloatercanberecallediswhenthecurrentlyrequiredmarginforthesecurityislowerthanwhatwasspecifiedearlier.Insuchasituation,thefloatercanberecalledandreplacedwithasecuritycarryingalowerquotedmargin.Aswehaveseenearlierinthecaseoffixedcouponsecurities,thecalloptionworksagainsttheinvestors.Iftheyreceivetheprincipalprematurely,theyhavetoreinvestitineitherasecuritywithalowercoupon,orasecuritywithasmallerquotedmargin.Floaterscancomewithputoptions,whereintheholdercansurrenderthebondpriortomaturity.Ifratesriseinthemarket,andthefloaterisputable,theholdercanreturn the bond, recover the principal, and reinvest it in a bond carrying a highercoupon,orinafloaterwithahigherquotedmargin.1Byshort-term,wemeanitisforaperiodlessthanorequaltooneyear.https://doi.org/10.1515/9781547400669-007
© 2019 Walter de Gruyter GmbH, Berlin/Munich/Boston

Chapters in this book

  1. Frontmatter I
  2. Advance Praise for Fixed Income Securities V
  3. Foreword VII
  4. Preface IX
  5. Acknowledgments XI
  6. Contents XIII
  7. Chapter 1. A Primer on the Time Value of Money 1
  8. Chapter 2. An Introduction to Bonds 30
  9. Chapter 3. Bonds: Advanced Concepts 65
  10. Chapter 4. Yield Curves and the Term Structure 97
  11. Chapter 5. Duration, Convexity, and Immunization 118
  12. Chapter 6. The Money Market 152
  13. Chapter 7. Floating Rate Bonds 183
  14. Chapter 8. Mortgage Loans 203
  15. Chapter 9. Mortgage-Backed Securities 233
  16. Chapter 10. A Primer on Derivatives 258
  17. Chapter 11. The Valuation of Interest Rate Options 305
  18. Chapter 12. Interest Rate Forwards and Futures 341
  19. Chapter 13. Bonds with Embedded Options 385
  20. Chapter 14. Interest Rate Swaps and Credit Default Swaps 416
  21. Appendix A 444
  22. Bibliography 446
  23. Index 448
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https://doi.org/10.1515/9781547400669-007

Chapters in this book

  1. Frontmatter I
  2. Advance Praise for Fixed Income Securities V
  3. Foreword VII
  4. Preface IX
  5. Acknowledgments XI
  6. Contents XIII
  7. Chapter 1. A Primer on the Time Value of Money 1
  8. Chapter 2. An Introduction to Bonds 30
  9. Chapter 3. Bonds: Advanced Concepts 65
  10. Chapter 4. Yield Curves and the Term Structure 97
  11. Chapter 5. Duration, Convexity, and Immunization 118
  12. Chapter 6. The Money Market 152
  13. Chapter 7. Floating Rate Bonds 183
  14. Chapter 8. Mortgage Loans 203
  15. Chapter 9. Mortgage-Backed Securities 233
  16. Chapter 10. A Primer on Derivatives 258
  17. Chapter 11. The Valuation of Interest Rate Options 305
  18. Chapter 12. Interest Rate Forwards and Futures 341
  19. Chapter 13. Bonds with Embedded Options 385
  20. Chapter 14. Interest Rate Swaps and Credit Default Swaps 416
  21. Appendix A 444
  22. Bibliography 446
  23. Index 448
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