24 March 2008
Floating Rate Notes – the unknown entities
The product: Floating Rate Notes are experiencing a renaissance in the treasury/money market, credit, and pension departments of many banks in these times of financial insecurity and volatile markets. They are also increasing in popularity among insurances, money market funds, hedge funds, central banks, and supranational issuers. Finally, institutional investors, such as industrial companies, retirement funds, or asset managers, use these variable rate bonds as an interest warrant oriented to a reference interest rate. This rate is usually the Euribor for issues in euros, usually for three months, but also sometimes for six or twelve and occasionally with other maturities. As a rule, the maturity corresponds to the payment frequency of the coupon. According to the rating of the issuer, an additional charge is paid in addition to the interest rate; the worse the rating of the debtor, the higher this additional charge. The Libor is usually at the basis of securities in dollars and pound sterling. Floaters are especially worthy of recommendation when interest rates are increasing because the investment is especially lucrative in phases of inverse yield curve because the profits are higher than with investments with fixed interest for a longer period of time. This leads to an increase in demand for variable rate bonds in times for inverse yield curve. Reverse Floating Rate Notes (reverse Floaters) offer a higher interest yield when the reference interest rate sinks. They thereby provide protection against sinking money market rates. Therefore, Floaters are also used as an alternative to time deposits at banks during phases of rising interest rates or insecurity about interest rates, and they are defensive investment instruments.
The valuation: According to the maturity and rating of the debtor, Floaters offer either a spread or a discount compared to the Euribor. This is expressed by a deviating quoted margin and discounted margin.
Different Floaters can be compared with each other through analysis of the respective discounted margin. Therefore, the discounted margin is the most typical valuation standard for Floaters. In contract, the quoted margin remains constant for the entire maturity of the Floater. As a rule, the higher the rating and standing of the issuer, the lower quoted margin. Similarly, some Floaters have a negative spread. The coupon of a Floater is composed of the variable part, i.e. the money market/reference interest rate, and the spread or discount in basis points as the fixed part.
Floaters are actually a mixed between a money market security and the security with a fixed interest rate. Therefore, the risk of interest rate risk also follows its own rules. On the one hand, the interest rate risk of a Floater is limited by regular adjustment to the money market rates, but, on the other hand the, credit/spread risk corresponds to the risk for comparable fixed coupon security.
Therefore, changes to the ratings usually have a large influence on the discounted margin. The daily calculation of the accrued interest is usually performed according to the actual/360 method. According to financial mathematics, the interest rate risk (duration) of a Floater somewhat corresponds to the coupon maturity until adjustment.
Generally, many factors influence the pricing of a Floater. The first factors considered for the valuation are the hard facts, such as solvency, ECB capability, public offering, and the reliability. Furthermore, the name recognition of the issuer, the region, maturity, and configuration are considered. Finally, the name of the issuer, its free line of credit at banks, the issue volume of the security, and the issuer’s possible need for refinancing round out the picture.
The product advantages: At times of steep interest curves on the capital market, the issuer can hope for lower interest payments overall. Floaters offer the issuer the opportunity to obtain long-term capital at short-term market-rate interest rates. Under certain circumstances this can also be less expensive than short-term roll over credit facilities because of saved management and transaction costs.
From the perspective of the investor, it is certainly advantageous that a Floater packaged as a security is comparable to time deposit but can be sold at any time. The defensive character of the product means that the investor can remain calm even in times of large interest rate fluctuations because the ongoing interest rate is regularly adjusted to the respective new interest rate level. Furthermore, the investment usually bears more interest that in the money market. The potential for loss because of interest rate related market fluctuations is lower than with fixed coupon bonds.
Furthermore, short-term bonds reduce the liquidity ratio (are grundsatzsenkend) in the sense of ‘Grundsatz II’, the liquidity principle. The exploitation of intermarket spreads compared to fixed securities and CDS can also be advantageous. The disadvantages of the product: the issuer cannot calculate the absolute interest payments at issue because the money market interest rates/ Euribor interest rates could vary greatly during the maturity. According to the wishes of the treasury, the security may have to be ‘swapped’ with a fixed base rate, which creates additional costs for the bonds. The investor may have to settle for low interest yields in phases of steep interest curves. If a Floater is purchased at a fixed Euribor spread (D.M.), the investor also bears the full risk of a change in rating and has no chance for a neutral pullout. The above-named variables can be it difficult to determine the returns. The frequent coupon payments every 3 or 6 months mean re-investment risk for the interest yields and/or more administrative effort for the investor. When short term interest rates are falling quickly, the investor can only participate from higher rates during the short period of his investment.
Floating Rate Notes as a strategic investment
In additional to the sometimes significantly higher interest yield of the securities compared to conventional interbank or time deposit investments, the product advantages described above can be played up for optimum yields by means of strategic investment planning. The huge demand for bonds with < 1 year’s time remaining to maturity means that 1.5 or 2 year issues are especially well suited for building up a portfolio on account of the usually steep credit/spread curves of many issuers. This is because there is a strong increase in value that reduces the credit spread after a holding period of 6 or 12 months if the rating and overall market spread remain the same.
After conclusion of the sale, further maturity extensions on the spread curve, i.e. a re-investment or switch in the same name or the name of an alternative issuer could be interesting. An investor can deliver an ECB capable Floater in the scope of tender transactions at the central bank and thereby usually generate inexpensive liquidity or attractive refinancing. It is possible to have a significantly higher yield compared to interbank timed deposits because most Floaters have a quoted margin between 15 and 40 base points above the Eurobor. Furthermore, it is also possible to issue securities repos for yield maximisation if there are short positions in certain securities.
