Floating Rate Notes

Introduction

A bond is a long term debt obligation. It is sold by the borrower who is called the "issuer" in order to borrow money for the medium and long term. Typically a bond will have a maturity of between 2 and 20 years. The issuer can be a bank, company or government institution. A bond normally has a  known maturity or redemption date and during its life pays the investor interest.  The interest payments are called "coupons". Bond investors rank prior to equity holders in liquidation but are subordinate to secured lenders. From an issuer’s perspective the coupons are usually tax deductible (unlike dividend payments on equity). Bond markets provide investors with variety. One of the most frequently issued bonds is called a floating rate note.

Floating Rate Notes, (FRNs)

FRNs pay the investor regular coupons every 3 or 6 months. The coupons are linked to a short term interest rate like 3 month or 6 month Libor.  Although they typically have maturities between 2 and 20 years they are often considered to be money market products by virtue of their linkage to Libor.  From an investor's perspective the cash flows on a bond appear as:

When a coupon is paid the next coupon is reset with reference to the relevant Libor rate. This means that the interest received by the investor fluctuates with short term money market interest rates. (The investor's interest receipts are not dissimilar to the regular reinvestment of an interbank deposit paying Libor; when short term interest rates go up, the coupon increases, when they go down the coupon falls).

The coupon payments are calculated on a money market basis, (actual 360 or actual 365). Here is an example. It assumes a principal amount of $10,000,000 with 6 month Libor settling at 3% and the day count being 182 days. The coupon payment is $151,666.67 six months in arrears of its fixing date:

It is not unusual to find FRNs that have an additional margin added to the coupon payment. For example 3 month Libor plus 25 basis points, this margin normally continues throughout the life of the bond and is added to the coupon payment each time it is made.

When dealers buy and sell FRNs the price they deal at excludes accrued interest (the clean price) when the trade is settled accrued interest is added in order to obtain the settlement price or dirty price. The addition of the accrued interest compensates the seller for the interest that has accumulated from the previous coupon payment date.

Interest rate risk

An FRN represents a series of Libor linked coupon payments. This means that when interest rates fluctuate the coupon will change. This has important implications for the FRN's price. With fixed coupon bonds rising interest rates leads to a fall in their value, (and falling rates a rise in value). This is a discounting effect with higher rates leading to a greater reduction in present value.

For FRNs when interest rates increase their coupons increase. This offsets the reduction in value that would normally occur from discounting the coupon payments using higher interest rates. As a consequence FRNs are far less price sensitive to changing interest rates.

It should be noted that a small reduction in the price of an FRN will normally occur when interest rates increase. This arises because the current coupon is already a fixed rate of interest:

FRNs with margins added to their coupon payments will also suffer a slight reduction in value when interest rates increase because these margins too are fixed for the life of the note.

This means that the FRN investor experiences much smaller gains and losses resulting from changing interest rates than the investor in a fixed coupon bond.

Credit & liquidity risk

The FRN investor does not however escape the effect of credit risk. If the market's perception of credit risk increases the value of an FRN will fall. This is because investors will require a greater investment return to compensate for the risk being taken.

Investors should also be aware that FRNs have been issued by banks in order to access wholesale markets for funding and capital. An FRN that is classified as "senior debt" is being used for funding purposes and offers an investor a lower risk and return than one that is "subordinated debt" and is being used to count towards capital. Investor's should always be fully aware of the seniority of the bond before an investment decision is made.

An additional factor that will also affect the price of an FRN is liquidity. In simple terms bonds that are liquid carry a liquidity premium, this means they are more expensive. An investor should always bear this in mind when comparing the returns on various FRNs.

Judging value

FRNs rarely trade at par vale (100% of principal) sometimes they are at a premium and sometimes they are at a discount to par value. So how can you determine their value particularly when you don’t know what the coupon payments will be in the future?

Many dealers use a discount margin calculation. Suppose a FRN had a price of 98%, matures in 5 years time and has a coupon of Libor, an investor could purchased $10,000,000  of this bond but only pays $9,800,000. The investment return would be Libor plus a capital gain of $200,000:

$200,000 over 5 years equates to $40,000 per annum or $40,000/$10,000,000 =  0.0040 (40 basis points). The simple margin is therefore Libor plus 40 basis points but this doesn’t take into account the time value of money.

If you invested the $200,000 at say 4% what payment could you make every 6 months for a period of 5 years before the $200,000 was exhausted?

A financial calculator shows the sum to be $22,265. How many basis points is this?

Assuming a six month period of 182 days:

$22,265/$10,000,000 x 360/182 =  0.0044 or 44 basis points

Therefore the FRN return including reinvested interest would be Libor plus 44 basis points, this is called the discounted margin.

Using the discounted margin

The discounted margin calculation allows dealers and investors to compare the relative value of different FRNs in a straight forward manner. A return of Libor plus 44 basis points is a lot easier to understand that one of Libor and a  capital gain of 2%.

You would normally expect FRNs with greater credit risks or lower liquidity to have higher discounted margins and this is indeed normal. However market anomalies do exist. Sometimes two FRNs with similar maturities, credit risks and liquidity may have different discounted margins. From a dealer's perspective the one with the highest margin offers better relative value.

First Published by Barbican Consulting Limited 2010