Floating-rate securities

Fabozzi, F., Mann, S.V., 2000. Floating-Rate Securities, first ed. John Wiley Sons. 

In contrast to a conpon rate that remains unchanged for the bond s entire life, a floating-rate security or floater is a debt instrument whose coupon rate is reset at designated dates based on the value of some reference rate. Thus, the coupon rate will vary over the instrument s life. The coupon rate is almost always determined by a coupon formula. For example, a floater issued by Aareal Bank AG in Denmark (due in May 2007) has a coupon formula equal to three month EURIBOR plus 20 basis points and delivers cash flows quarterly. 

Callable bonds, putable bonds, mortgage-backed securities, and asset-backed securities are examples of (1). Floating-rate securities and inflation-indexed bonds are examples of (2). Convertible bonds and exchangeable bonds are examples of (3). 

Numerous duration measures are routinely employed by fixed-income practitioners that relate to both fixed-rate and floating-rate securities. Furthermore, there are more sophisticated duration measures that allow for nonparallel yield curve shifts. We discuss these measures in this section. 

The cost of capital is what it costs a company to borrow money from aU sources. Three general sources of capital available are borrowed money, equity capital, and retained earnings. For borrowed capital (from investment houses, banks, insurance companies, and venture capitalists), the interest rate on loans is a few percentage points above the prevailing prime interest rate. The interest rate charged also depends on the length of the loan, size of the loan, and potential risk perceived by the lender. For equity capital, obtained from the sale of preferred and/or common stock, companies may float new stock issues or have shares of stock that may be released to secure capital funds. Retained earnings or reserves may be used to the extent of their availability. 

Under the secured loan structure, the trustee might find it necessary under certain circumstances to enforce the fixed and floating charges. Such circumstances could include unremedied events of default under the issuer-borrower loan, or if third-party creditors were to attempt to put the company into administration. In this case, the trustee would seek to have an administrative receiver appointed on behalf of the secured creditors. However, the process could disrupt the receipt and payment of cash flows. The ratings of the notes are based on timely payment of interest (and sometimes principal) so the transaction will include some form of liquidity support, which is typically sized to enable the issuer to cover one year s debt service. 

Notes issued in synthetic structures are organized by tranche. With the proceeds from the notes it issues to investors, the SPV purchases high-quality (AAA) liquid securities—for example, U.S. Treasuries, bank asset-backed paper such as credit card ABS, and German bonds, such as Pfandbriefe —to serve as collateral. This collateral will generate LIBOR-related interest and principal cash flows that the SPV passes on to the investors together with the swap premium, which creates an additional credit spread on the notes. The cash flows from the collateral may not match the payments due on the issued notes—for example, the bonds used as collateral may pay a flxed rate and the issued notes a floating one. To remedy this, the... 

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