Floating Rate Bonds
Floating rate bonds are expressed as a reference rate plus a spread or margin. The spread is usually set and stays constant until maturity and it is primarily a function of the issuer’s credit quality. The coupon rate adjusts to the level of market interest rates depending on the reference rate.
The London InterBank Offered Rate (LIBOR) is the reference rate for many floating bonds. For floating-rate bonds denominated in US dollars, the reference rate is the US dollar LIBOR and 3-month LIBOR if the coupons are paid quarterly. Libor rates reflect the rates at which multiple banks believe they could borrow unsecured funds from one another. Historically, LIBOR rates were set by the British Bankers’ Association (BBA).
The major advantage of the LIBOR is its prevalence of use. However, the main disadvantage is its dependence on the bank’s own estimates of their borrowing rates.
The interest on a floating-rate debt is calculated as the reference rate (usually the LIBOR) plus a spread, where the spread is a function of the issuer’s credit quality. For example, a stable AAA-rated financial institution will have a spread of 0.5-2% whereas a riskier issuer will have a higher spread.
Fixed Income Indexes
Fixed income indexes describe a given bond market or sector to measure and report performance. Barclays’ Capital Global Aggregate Bond Index represents a broad global investment-grade fixed-rate bond market with 3 components: US, Pan-European, and Asian-Pacific Aggregate Bond Indexes.
For a floating-rate bond, the coupon rate is the 3-month LIBOR plus a given spread. The coupon payments are likely to decrease if the:
A. LIBOR decreases
B. Spread decreases
C. Company’s credit quality increases
The correct answer is A.
The LIBOR is the only component that is subject to change.
Options B and C are incorrect. The spread is usually set and stays constant until maturity and is primarily a function of the issuer’s credit quality.
Reading 43 LOS 43b:
Describe the use of interbank offered rates as reference rates in floating-rate debt