The structure of floating-rate securities, such as the coupon formula and the caps and floors features, and the mechanics of the payments and the coupon rate resetting are now examined.
The typical coupon formula is:
Coupon rate = reference rate + quoted margin
The reference rate generally reflects the market conditions, often represented by the risk-free rates in the market such as yields of government bonds or interbank offer rates.
The quoted margin is the additional interest rate that the issuer agrees to pay above the reference rate. It indicates the additional compensation that an investor requires. The quoted margin can occasionally be a negative value creating a coupon rate lower than the reference rate.
To protect an issuer from rampant hikes in interest rates, often a maximum limit is set. A cap is a maximum rate for a coupon that can be reached regardless of how high the reference rate goes.
Caps are naturally unattractive to investors.
Conversely, a floor is its minimum, which is in place to protect the investor. If a bond has a cap and a floor, the feature is called a collar.
There are various different types of floating-rate securities, which are often structured with the use of derivative instruments. Following is a list of examples:
The coupon formula is:
Coupon rate = K – L x (reference rate)
Where K and L are values specified in the prospectus or the indenture for the issue in such a way that the movement of the resulting coupon rate is opposite to the market move.
The coupon formula:
Coupon rate = (R1 – R2) + quoted margin
Where R1 and R2 are two pre-specified reference rates.
The issuer can only adjust the coupon rates downwards based on the coupon formula. Once the coupon rate falls due to the reference rate drop, the coupon rate cannot be adjusted up if the reference rate subsequently rises. coupon rate = R + quoted margin where R will always be equal to the lowest recorded reference rate during the life of the issue.
The quoted margin of this type of security can be adjusted up or down at certain intervals during the life of the security as specified in the indenture. The quoted margin will be stepped down if it is expected that the issuer’s risk will improve during the course of time, or stepped up if the issuer’s risk deteriorates.
Coupon rate = reference rate + QM
Where QM, the quoted margin, will follow a resetting schedule over the life of the issue.
A floating-rate security where the coupon rate can be changed depending on market conditions, so the issue will trade at a pre-determined price, is called an extendible reset bond. The new rate will reflect the market interest rate and the required margin. Unlike a typical floater with a fixed quoted margin, this coupon formula will take into account the dynamics of the market perception of the issuer risk.
Coupon rate = reference rate + QM
In this case the sum of the reference rate and QM, the quoted margin, will usually make the issue trade at a minimum of par value.
The reference rate in the coupon formula can take a wide variety of indices other than an interest rate or an interest index. With the latest financial engineering techniques, any reference rate can now be used, such as the price of a commodity (e.g. gold or crude oil), the return of an equity index (e.g. S&P 500), or others.
Another popular reference rate is an inflation index. The U.S. Department of Treasury issued Treasury Inflation Protection Securities (TIPS), and other commercial entities have already begun issuing inflation-indexed bonds.
Coupon rate = b x (reference rate) + quoted margin
Where b is between 0 and 1
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