Floating-Rate Securities

Rather than paying a fixed rate of interest, floating-rate securities (or floaters) offer interest payments which reset periodically, with rates tied to a representative interest rate index. Floaters were first issued during a period of extreme interest rate volatility during the late 1970s.

From the investor’s perspective, floaters can offer enhanced yields when compared to a strategy of rolling over comparably rated short-term instruments and paying the related costs associated with each transaction. Floating-rate securities also allow investors to match asset and liability cash flows.

Base Index
Indices used to set the interest rate on floaters include:

• CMT: Constant Maturity Treasury Index
• COFI: Cost of Funds Index, typically the one published by the 11th District Federal
• Home Loan Bank
• CP: Federal Reserve Commercial Paper Composite
• Fed Funds Rate
• LIBOR: London Interbank Offered Rate for U.S. dollars and other currencies: three-month, six-month or one year
• Prime Rate
• Treasury bill rates: three-month, six-month or one year
• Foreign interest rate or currency exchange rate:

The rate may also be set as some combination of the above, such as Prime minus 10-year CMT plus three-month LIBOR.

Yield Spreads
Floater yields are typically defined as a certain number of basis points (or spread) over or under the designated index. Floaters based on indices such as T-bills will generally add the spread (e.g., the interest rate will be T-bill plus 40 basis points), while those based on other indices such as the prime rate might have the spread subtracted from the rate (e.g., the interest rate will be Prime minus 240 basis points). Typically, spreads are set when the securities are priced and remain fixed until maturity so that changing interest rates affect the amount of interest paid on the security but not the spread.

When floating-rate securities are purchased at a price other than par, the difference between the purchase price and par is converted to a percentage and discounted for the remaining life of the security to calculate an effective yield, also known as the discount margin or sometimes as “spread for life.”

Reset Periods
The interest rate on floaters may be reset daily, weekly, monthly, quarterly, semiannually or annually. In some cases, the reset period will be determined by the index used. Fed funds floaters, for example, might reset daily because the rate is an overnight rate, while T-bill floaters usually reset weekly following the weekly T-bill auction. Some floaters, particularly those with more frequent resets, set their rate as of a date prior to the coupon payment date.

The period between the date the rate is set and the payment date is referred to as a “lock-out” period. Floaters with longer reset periods may be more vulnerable to interest rate and price volatility.

Day Count Periods
Floating-rate securities generally use a month/year day count convention of 30/360, actual/360 or actual/actual to calculate the number of days in the interest payment period.

For example, a security with a 30/360 convention assumes there are 30 days in every month and 360 days in every year. As a result, the rate of interest accrues daily at 1/360th of the nominal interest rate for the calculated number of days in the interest period; even in a 31-day month, interest is calculated on the basis of 30 days.

Actual/360 uses the actual number of days in the month and a 360-day year; actual/actual uses the actual number of days in both the month and the year. Day count periods can vary by issuer and by issue. They are disclosed in offering documents.

Payment Periods
Interest payments on floaters may be made monthly, quarterly, semiannually or annually. Interest on floaters is usually not compounded, but the more frequent the payments, the more the investor stands to earn from reinvesting. The higher the prevailing interest rate for reinvested funds, the more noticeable this potential compounding effect will be.

Maturity
Floaters may be issued with any maturity, and those with longer maturities generally carry a slight yield premium. With a fixed-rate security, the yield premium for longer maturities tends to compensate investors for credit and interest rate risk during the time the security is outstanding. Yield premiums for longer maturities on floating-rate securities can also reflect the possibility of credit changes and, to a lesser degree, interest rate movements.

Interest Rate or Coupon
Because the interest payment on a floater is tied to an index through some formula, the actual interest paid may be lower than the rate paid on a conventional fixed-rate debt security. For some issues, a zero interest rate is possible.

Note too that floaters tied to indices such as COFI or Prime, which tend to lag behind the market, may perform better in a falling-rate environment, while floaters tied to coincident market indices such as LIBOR may do better in a rising-rate environment.

Floaters tied to T-bills, meanwhile, can suffer from falling rates created by high T-bill demand during times of political crisis or extreme market shifts. Investors should remember that not all indices perform alike under different interest rate scenarios.

Valuation
The secondary market value of a floater is based on the volatility of the base index, the time remaining to maturity, the outstanding amount of such securities, market interest rates and the credit quality or perceived financial status of the issuer. Each of these factors is dynamic, and can result in higher or lower secondary market values.

As with all securities, supply and demand must be taken into consideration. With respect to demand, investors should keep in mind that securities structured to meet the needs of a particular investor may have limited liquidity because of the challenge of finding another buyer.

Basis Risk
Basis generally refers to the difference between two indices. Basis risk refers to the possibility that this difference will change in an unanticipated manner. For example, if an investor with liabilities tied to one index, such as the T-bill rate, matches those liabilities to assets tied to another rate, such as LIBOR, the investor could be subject to basis risk if the two rates move in different directions than expected or at differing rates of change.