Floating Rate Notes

A fixed-rate bond pays fixed coupons during the bond s life known with certainty. Conversely, a floating-rate note ox floater pays variable coupons linked to a reference rate. This makes the coupon payments uncertain. The main pim-pose of this debt instrument is to hedge the risk of rising interest rates. Although the financial crisis and liquidity provided by central banks have decreased the level of interest rates, they will at some point of course rise in future years. 

As introduced, the reference rate represents the interest rate or index used to obtain the linkage. In the European market, the major parts of floating-rate note issuances are linked to the Euribor and the remaining to the constant maturity swap. In the US and UK markets, they are tied to the Libor and short-term treasury bonds. 

In Chapter 8, we described several models to measure the term structure of credit spread and we introduced the model proposed by Longstaff and Schwartz (1995) for pricing fixed-rate debt. The authors propose also a model to valuing floating-rate notes. The equation derived for pricing floating-rate bonds is given by (10.2) ... 

The authors find that conversely to the price of a fixed-rate coupon payment, which is a decreasing function of the maturity T, with floating-rate notes, the value depends on the level of interest rates. In fact, when the interest rate is below the long-run average value, the increase of T reduces the value of the floater and vice versa. In addition, the price of a floating-rate note increases with rising risk-free interest rates. 

The pricing of a floating-rate note at issue does not differ from a conventional bond. In fact, it is the present value of coupon payments and principal repayment and is given by (10.3) ... 

Take the Position in Floating-Rate Note Market... 

Chapter 8 shows several spread measures that can be used to compare fixed-rate bonds. Conventionally for floating-rate notes, traders use the discounted margin. To analyse a floating-rate note with a fixed-rate note, one method is to compare the discounted margin of a floater with the asset swap spread of fixed-rate bonds. 

Another approach is to compare the floating-rate note with a derived yield of a fixed-rate bond by using an interest rate swap curve matched with floater coupons. Figure 10.4 shows the Bloomberg YASN screen for Mediobanca float... 

OTHER FEATURES OF FLOATING-RATE NOTES 10.4.1 Duration... 

Moreover, duration will be influenced by the floater s stmcture. In fact, the choice of the reference rate affects the duration depending on how much volatile the index is. The lower the frequency of couptm payments, the greater the price sensitivity between reset dates. Thus, while floating-rate notes have a lower price sensitivity to a change of the reference rate, fixed and floating-rate notes both have a price sensitivity to changes of credit spread reflecting the issuer s creditworthiness. A shift of the credit term structure will determine the decline of the bond s price. 

Floating-rate notes can include additional features. One example is the inclusion of cap, floor and collar clauses. A floater with cap feature means that the reference rate cannot overcome the threshold rate defined in the indenture. Usually the threshold is expressed in terms of coupon, that is after a coupon threshold (e.g. 6%, reference rate plus quoted margin) the investor receives at maximum the cap level. In this case, the floater is not completely covered by rising interest rates, in which after the threshold the floater trades as a conventional bond. In contrast, a floater with a floor feature represents the minimum coupon level that an investor can receive, hedging to the downside risk of interest rates. If the bond includes both cap and floor, this feature is known as collar or collared floating-rate note. The bond can include also a drop-lock feature that after a threshold it ceases to float. 

An inverse floating-rate note pays coupons that increase if the reference rate decreases. Therefore, this bond gives a benefit at investors with a negative yield curve. The coupon structure of inverse floaters usually is determined as a fixed interest rate less a variable interest rate linked to a reference index. Moreover, they can include floor provisimis. 

What is worthy then of a further investment of cash to purchase this second edition Hopefully the new chapters on asset swap spread relative value, convertible bonds, callable/putable bonds and floating-rate notes will be sufficient justification additionally we have updated the previous chapters on inflation-linked bonds and risky corporate bonds valuation. We have also included Excel spreadsheets that enable the reader to apply the analysis described in the chapters right away to bonds that he or she selects. 

An index-linked bond has its coupon or maturity value or sometimes both linked to a specific index. When governments issue index-linked bonds, the cash flows are linked to a price index such as consumer or commodity prices. Corporations have also issued index-linked bonds that are connected to either an inflation index or a stock market index. For example, Kredit Fuer Wiederaufbau, a special purpose bank in Denmark, issued a floating-rate note in March 2003 whose coupon rate will be linked to the Eurozone CPI (excluding tobacco) beginning in September 2004. Inflation-indexed bonds are detailed in Chapter 8. 

Floating-rate notes (FRNs) are Eurobonds that have their coupon levels reset periodically, with reference to a money market rate. For dollar-denominated assets, this is LIBOR (the London Inter-bank Offer Rate) as determined by a group of 16 reference banks. The mechanism is run by the British Bankers Association (BBA). The BBA also supervises LIBOR fixings in a number of other currencies. For euros, the most common reference rate is EURIBOR, as determined by a reference group of around 50 banks chosen by European Banking Federation. In both cases, most issues are priced off of the three-month rate, although one-month and six-month rates are also used. 

The European CMBS market presents investors with a wide variety of investment opportunities ranging from short-dated floating-rate notes to long-dated, fixed-rate issues across a rating spectrum from AAA to BB, and so it should appeal to a wide section of the investor community. It is, however, a relatively complex asset class. There are many underlying asset types, which can be spread across more than one country, and there are a number of possible transaction structures. As a result, it is not always easy to compare one transaction against another. 

The majority of issues since 1995 have come with floating-rate notes. However, in the latter part of 2000, demand for the asset class was expressed by fixed-rate buyers and MBNA EBL issued two fixed-rate transactions, one euro- and one sterling-denominated. Both issues had 10-year maturities and capitalised on the relatively small supply of consumer asset securitisations available in that sector of the curve. Exhibit 13.4 shows issuers of European CCABS ranked by cumulative issuance. 

A capped note is like a regular floating-rate note (FRN), but paying an enhanced return subject to an absolute cap on interest rates. For example, with 6-month EURIBOR currently at 2%, a regular 3-year FRN issued by XYZ Corp might pay 6-month EURIBOR plus 40 bp. A 3-year capped note from XYZ might pay 6-month EURIBOR plus 50 bp, subject to a maximum rate of 3.5%. 

Floating-rate notes (FRNs) represent an opportunity to buy short duration corporate paper, and are an attractive instrument to manage dura-... 

Final allotments of floating-rate notes denominated in US dollars or sterling should be in denominations of one milHon or multiples. 

Floating-rate bonds, often referred to as floating-rate notes (FRNs), also exist. The coupon rates of these bonds are reset periodically according to a predetermined benchmark, such as 3-month or 6-month LIBOR (London interbank offered rate). LIBOR is the official benchmark rate at which commercial banks will lend funds to other banks in the interbank market. It is an average of the offered rates posted by all the main commercial banks, and is reported by the British Bankers Association at 11.00 hours each business day. For this reason, FRNs typically trade more like money market instruments than like conventional bonds. 

A long 100 million position in a 3-year floating-rate note (FRN) that pays 6-month LIBOR semiannually and is trading at par... 

Current pt. Current-pay bonds have been issued in Turkey. They are similar to interest-indexed bonds in that their redemption payments at maturity are not adjusted for inflation. They differ, however, in their term cash flows. Current-pay bonds pay an inflation-adjusted coupon plus an indexed amount that is related to the principal. In effect, they are inflation-indexed floating-rate notes. 

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