The change in the price of a fixed-rate security when market rates change is due to the fact that the security’s coupon rate differs from the prevailing market rate. So, an investor in a 10-year 7% coupon bond purchased at par, for example, will find that the price of this bond will decline below par value if the market requires a yield greater than 7%.By contrast, for a floater, the coupon is reset periodically, reducing a floater’s price sensitivity to changes in rates. For this reason, floaters are said to more “defensive” securities. However, this does not mean that a floater’s price will not change.
Factors that Affect the Price of a Floater
A floater’s price will change depending on the following factors:
Below we discuss the impact of each of these factors.
Time Remaining to the Next Coupon Reset Date
The longer the time to the next coupon reset date, the greater a floater’s potential price fluctuation. Conversely, the less time to the next coupon reset date, the smaller the floater’s potential price fluctuation.
To understand why, consider a floater with five years remaining to maturity whose coupon formula is the 1-year Treasury bill rate plus 50 basis points and the coupon is reset today when the 1-year Treasury bill rate is 5.5%. The coupon rate will then be set at 6% for the year. One month from now, the investor in this floater would effectively own an 11-month instrument with a 6% coupon. Suppose that at that time, the market wants a 6.2% yield on comparable issues with 11 months remaining to maturity. Then, our floater would be offering a below market rate (6% versus 6.2%). The floater’s price must decline below par to compensate for the sub-market yield. Similarly, if the yield that the market requires on a comparable instrument with a maturity of 11 months is less than 6%, the price of a floater will trade above par. For a floater in which the cap is not reached and for which the market does not demand a margin different from the quoted margin, a floater that resets daily will trade at par value.
Whether or Not the Market’s Required Margin Changes
At the initial offering of a floater, the issuer will set the quoted margin based on market conditions so that the security will trade near par. If after the initial offering the market requires a higher margin, the floater’s price will decline to reflect the higher spread. We shall refer to the margin that is demanded by the market as the required margin. So,for example, consider a floater whose coupon formula is 1-month LIBOR plus 40 basis points. If market conditions change such that there quired margin increases to 50 basis points, this floater would be offering a below market quoted margin. As a result, the floater’s price will decline below par value. The price can trade above par value if the required margin is less than the quoted margin—less than 40 basis points in our example.
The required margin for a specific issue depends on: (1) the margin available in competitive funding markets, (2) the credit quality of the issue, (3) the presence of the embedded call or put options, and (4) the liquidity of the issue. In the case of floaters, an alternative funding source is a syndicated loan. Consequently, the required margin will be affected by margins available in the syndicated loan market.
The portion of the required margin attributable to credit quality is referred to as the credit spread. The risk that there will be an increase in the credit spread required by the market is called credit spread risk. The concern for credit spread risk applies not only to an individual issue,but to a sector and the economy as a whole. For example, the credit spread of an individual issuer may change not due to that issuer but to the sector or the economy as a whole.
A portion of the required margin will reflect the call risk associated with the floater. Because the call feature is a disadvantage to the investor,the greater the call risk, the higher the quoted margin at issuance.After issuance, depending on how rates and margins change in the market,the perceived call risk and the margin attributable to this risk will change accordingly. In contrast to call risk due to the presence of the call provision, a put provision is an advantage to the investor. If a floater is putable at par, all other factors constant, its price should trade at par near the put date.
Finally, a portion of the quoted margin at issuance will reflect the perceived liquidity of the issue. The risk that the required margin attributable to liquidity will increase due to market participants’ perception of a deterioration in the issue’s liquidity is called liquidity risk. Investors in non-traditional floater products are particularly concerned with liquidity risk.
Whether or Not the Cap or Floor Is Reached
For a floater with a cap, once the coupon rate as specified by the coupon formula rises above the cap, the floater then offers a below market coupon rate, and its price will decline below par. The floater will trade more and more like a fixed-rate security the further the capped rate is below the prevailing market rate. This risk that the value of the floater will decline because the cap is reached is referred to as cap risk.
On the other side of the coin, if the floater has a floor, once the floor is reached, all other factors constant, the floater will trade at par value or at a premium to par if the coupon rate is above the prevailing rate for comparable issues.
Duration of Floaters
We have just described how a floater’s price will react to a change in the required margin, holding all other factors constant. Duration is the measure used by managers to quantify the sensitivity of the price of any security or a portfolio to changes in interest rates. Basically, the duration of a security is the approximate percentage change in a bond’s price or a portfolio’s value for a 100 basis point change in rates.
Two measures have been developed to estimate the sensitivity of a floater to each component of the coupon formula. Index duration is a measure of the price sensitivity of a floater to changes in the referencerate holding the quoted margin constant. Spread duration measures a floater’s price sensitivity to a change in the “spread” or “quoted margin”assuming that the reference rate is unchanged.
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