A floater is a fixed income instrument whose coupon fluctuates with some designated reference rate. Syndicated loans are usually structured as floaters, as are floating rate notes, which are discussed below.
A floating rate note (FRN) is a floater issued by a corporation, sovereign or government sponsored enterprise. Typically, FRNs have maturities of about five years. Three-month or six-month Libor are two commonly-used reference rates, as are Treasury bill yields, the prime rate or the Fed funds rate. Collateralized mortgage obligations (CMOs) are also sometimes structured to have floating rate coupons. These are called floating rate CMOs. If collateral comprises fixed rate mortgages, they can be structured by pairing offsetting floater and inverse floater tranches.
For FRNs, the coupon rate is usually reset each time interest is paid. A reset date is any date on which the reset takes place based on the value of the index on that date. A typical arrangement is to pay interest at the end of each quarter based on the value of 3-month Libor two business days before the start of that quarter. The coupon rate is calculated as the reference rate plus a fixed spread, which depends upon the issuer’s credit quality and specifics of how the instrument is structured. One feature that can affect the spread is provisions that place a cap or floor on the floating coupon rate. For example, an FRN might be issued with a cap of 7.5% and a floor of 1.5%.
Unlike a fixed-rate coupon bond, a floater’s market value depends almost entirely on the issuer’s credit quality because there is little or no interest rate risk associated with a floater. To illustrate why, consider how we might value a floater that has no credit risk.
At first, even this may appear to be a daunting task. Future cash flows depend upon as-yet undetermined future values of the reference rate. How can we value those cash flows if we know their timing but not their magnitude? There is a surprisingly simple answer. Let’s illustrate with an example.
Suppose we purchased a USD 10MM 2-year credit-risk-free FRN a month ago. It pays 6-month Libor flat. The initial value for the reference rate was 2.8%, so we will receive our first coupon of USD 0.142MM in five months (assuming, for this example, 183 days in the first coupon period). To value the instrument, let’s decompose it into four pieces:
- A cash flow of USD 10.142MM to be received in five months.
- A forward contract to invest USD 10MM for a period of six months starting five months from today. The interest rate will be the value of 6-month Libor at the start of that period.
- A forward contract to invest USD 10MM for a period of six months starting eleven months from today. The interest rate will be the value of 6-month Libor at the start of that period.
- A forward contract to invest USD 10MM for a period of six months starting seventeen months from today. The interest rate will be the value of 6-month Libor at the start of that period.
The value of the FRN will be the sum value of these four components.
Let’s start with the last three components—the forwards. These aren’t standard forward rate agreements, which lock in a future interest rate. Instead, these simply guarantee to pay whatever Libor rate is quoted in the market at the onset of their respective interest periods. How much are these guarantees worth? The answer is nothing. All three forwards have no value.
To see why, consider a similar guarantee. Suppose I guarantee to sell you an ounce of gold three months from now at whatever is the market price of gold at that time. What is this guarantee worth? It is worthless. You, or anyone, will be able to buy gold three months from now at the then-current market price of gold. This is true irrespective of my guarantee, so my guarantee is worthless. In the exact same way, a forward on a loan that guarantees interest at whatever Libor rate is available at the start of the loan is also worthless.
Of the above four components, the last three—the forwards—all have zero market value. This leaves the first component. It comprises a single future cash flow. Its market value is the discounted value of that cash flow. Accordingly, the market value of the FRN is also the discounted value of that cash flow. (Note, referring back to the above four components, the cash flow isn’t merely the coupon payment. It is the coupon payment and an imputed return of principal.)
This is a general result. The value of an FRN paying Libor flat is simply the value of the next coupon plus the principal—both discounted from the next coupon date.
If an FRN pays a spread over Libor, we generalize the above argument by splitting the instrument into two components:
- An FRN paying Libor flat.
- An annuity that lasts the life of the FRN and pays coupons equal to the dollar value of the spread.
The first is valued as above. The second is a stream of fixed cash flows. Its value is simply the sum of the discounted values of those cash flows. Note that both of the above components entail interest rate risk. We have already explained why this is modest for the FRN paying Libor flat. It is modest for the annuity because its cash flows are generally small relative to those of the first component, so its contribution to the overall instrument’s interest rate risk is small. For these reasons, a credit-risk-free FRN tends to have a stable market value. With an FRN paying Libor flat, the duration of the FRN is the time until the next interest payment. If it pays a spread over Libor, that spread will tend to increase the duration, but a credit-risk-free FRN will generally trade close to its par value.
Based on the above discussion, holding an FRN is like investing in a money market instrument and a small fixed annuity. The significant difference is the fact that the “money market instrument” essentially involves a commitment to keep reinvesting for the life of the FRN. This entails long-term credit exposure to the issuer, and this is typically reflected in the FRN’s spread.
Because an FRN entails little interest rate risk, its risk—and hence its price—is primarily determined by the instrument’s time to maturity and the credit quality of the issuer. In this sense, the FRN is almost a pure credit play. It is like a credit derivative in this respect.