Introduction
A bond represents a long-term debt commitment. When an entity wants to borrow money for medium to long durations, they sell bonds. These bonds usually mature in a period ranging from 2 to 20 years. Entities such as banks, corporations, or governmental bodies can issue them. Throughout the bond's life, the issuer pays the bondholder periodic interest, commonly referred to as "coupons". In the event of a liquidation, bondholders are prioritized before equity shareholders but stand behind secured lenders. Notably, for the issuer, the interest paid on bonds (coupons) often benefits from tax deductions, unlike dividends on shares. The bond market offers a diversified array of options, with the Floating Rate Note (FRN) being a popular choice among them.
Floating Rate Notes (FRNs)
FRNs offer periodic coupon payments, usually every 3 or 6 months, to the investor. These payments are tied to short-term interest rates, such as the 3-month or 6-month Libor. While FRNs usually have a maturity ranging from 2 to 20 years, their connection to Libor often categorizes them as money market products in the eyes of many. To understand the returns from a bond, an investor should consider the following cash flow structure:
Coupon Resets and Libor Linkage
Each time a coupon is paid, its next value is adjusted based on the prevailing Libor rate. This implies that the interest income for the bondholder changes in sync with the short-term market interest rates. Thus, the returns an investor gets from these coupon payments are somewhat comparable to continuously reinvesting in an interbank deposit that yields Libor. In simpler terms, when short-term rates rise, so does the coupon value; conversely, it declines when the rates drop.
Calculation of Coupon Payments
These coupon payments are determined using a money market approach, typically using an "actual 360" or "actual 365" day count convention. Let's illustrate with a practical example. Let's assume an investment in a bond with a principal amount of $10,000,000. If the 6-month Libor stands at 3% and the duration under consideration is 182 days, the resultant coupon payment, due six months after its determination date, would be $151,666.67:
Coupon Margins on FRNs
It's common for FRNs to have an additional margin incorporated into their coupon payments. For instance, a coupon might be defined as the 3-month Libor plus an extra 25 basis points. This margin typically remains consistent throughout the bond's tenure and is added to every coupon payment.
Pricing of FRNs: Clean vs. Dirty
When traders transact in FRNs, the quoted price typically omits any accrued interest and is thus referred to as the "clean price." However, during settlement, this accrued interest is factored in to derive the "dirty price" or settlement price. This addition ensures the seller is compensated for the interest that has built up since the last coupon payment date.
Interest Rate Risk and FRNs
An FRN essentially offers a stream of Libor-linked coupon payments, meaning its coupons adjust with the ebbs and flows of interest rates. This dynamic has significant implications for the FRN's pricing. For traditional fixed coupon bonds, an uptick in interest rates results in a dip in their value due to the discounting effect—higher rates diminish the present value more significantly.
However, FRNs behave differently. When interest rates climb, so do their coupons, counteracting the potential devaluation from the discounting of future payments at these higher rates. Hence, FRNs are much less vulnerable to price fluctuations stemming from interest rate shifts.
It's worth mentioning that a minor dip in the price of an FRN can occur when interest rates surge. This is because the coupon rate in effect at that time is already locked in at a fixed rate:
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 Risks
While FRN investors enjoy some insulation from interest rate fluctuations, they are still exposed to credit risk. If the broader market grows more wary of credit risks, an FRN's value might diminish. This drop in value is a reflection of investors' demand for a higher return as compensation for the perceived heightened risk.
Liquidity is another vital consideration that impacts the pricing of an FRN. In layman's terms, bonds with better liquidity often come with a liquidity premium, making them pricier. Investors must account for this when juxtaposing the returns of different FRNs.
Assessing Value
FRNs don't always trade at their face value, also known as par value. They might be priced at a premium or a discount. Given the unpredictability of future coupon payments, how does one estimate their value?
A popular method employed by dealers is the discount margin calculation. For instance, if an FRN is priced at 98% of its face value, set to mature in 5 years, and bears a coupon linked to Libor, an investor could acquire this bond with a principal of $10,000,000 for an outlay of just $9,800,000.
Here, the investor's return would be the sum of the Libor-linked interest and a capital appreciation 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 methodology provides both dealers and investors a streamlined way to gauge the relative worth of various FRNs. Interpreting a return of Libor plus 44 basis points is considerably more intuitive than one based on Libor combined with a 2% capital gain.
Generally, FRNs accompanied by heightened credit risks or diminished liquidity tend to exhibit larger discounted margins. This trend aligns with expectations. Yet, market inconsistencies do occur. There could be scenarios where two FRNs, even with analogous maturities, credit risks, and liquidity levels, display divergent discounted margins. For dealers, the FRN boasting a heftier margin typically represents a more attractive value proposition.