Yield and Yield Spread Measures for Floating-Rate Notes
Exactly!
Since the floating-rate note's coupon payments are set to adjust with the reference rate, they will change while the fixed-rate bond's coupons do not. This means that the FRN's price will not need to adjust nearly as much as that of the fixed-rate bond.
Suppose James, an investor, wanted a bond with a little more price stability.
He purchased a __floating-rate note (FRN)__ that doesn't have a set coupon payment. Instead, each year, James will receive a coupon payment based on the __reference rate__ in the FRN plus the __quoted margin__. For James's bond, the reference rate is a 6-month market reference rate (MRR), and the quoted margin is 1.25%.
James's quoted margin of 1.25% allows his next coupon to increase with the MRR, which is nice, but he noticed something odd. When the next coupon payment arrived, his bond was published as being at a discount price of 99.4.
What do you think is a likely reason for this price change in James's FRN?
No.
The higher coupon was simply an interest rate adjustment, which should have left the bond priced at par.
No.
If investors really expected interest rates to decline, the price of existing bonds would increase slightly.
Right!
The floating-rate structure of the bond is nice in capturing changes to the reference rate, but that's not the only variable important in a bond price. If the issuer has a credit downgrade, the price of issued bonds will be affected since it will not be at all reflected in the bond's cash flows.
This credit downgrade causes a change in the bond's __required margin__, which is the margin necessary to keep the bond at par value. James's quoted margin is 1.25%. It was set at the beginning to capture the issuer's credit rating, the bond's liquidity, etc., but now that quoted margin just isn't enough.
What do you think would happen if the reference rate on James's bond decreased as the issuer's credit rating improved a little?
No.
The floating coupon payments will change more, giving the FRN more price stability. The present value of cash flows won't change as much since the cash flows themselves are adjusting to the higher interest rate.
Exactly!
The bond's quoted margin is 1.25%, and that doesn't change. A decrease in the MRR would cause a decrease in coupon payments, which alone wouldn't change the bond's price or the required margin, but the improvement in the issuer's credit rating would be good for investors, lowering the margin required for the bonds to be at par value.
No.
The required margin would not increase. The improved credit rating would lower the margin required to bring the bond to par.
So, for the bond to be priced at par, the quoted margin has to be the same as the required margin. How would you clearly state the result of any difference between the two?
No.
Think about the fact that investors are demanding a higher margin than they did at issuance, and what sort of thing would cause that change.
To summarize this discussion:
[[summary]]
No.
This difference isn't related to the coupon payments. Coupons are a function of the par value, the reference rate, and the quoted margin.
No.
The quoted margin is fixed at 1.25%.
What do you think will happen to the price and coupons of this bond, compared to those of a similar fixed-rate bond, if the MRR increases?
No.
If the MRR increases, the FRN's coupons will change while the coupons of the fixed-rate bond will not.
Yes!
A higher required margin means something bad has happened like greater risk of default, less liquidity, or something else that investors don't like. A required margin above the quoted margin means that the bond is valued at a discount price.
The increased coupon
A lower expected future coupon
Some change in the credit quality of the issuer
The quoted margin and required margin would both decrease
The quoted margin would be unchanged, and the required margin would decrease
The quoted margin would be unchanged, and the required margin would increase
If the required margin is greater than the quoted margin, the price will be at a premium
If the required margin is greater than the quoted margin, the price will be at a discount
If the required margin is greater than the quoted margin, coupon payments will be higher than expected
The FRN's price and coupons will change more than those of the fixed-rate bond
The FRN's price will change less than that of the fixed-rate bond, but the FRN's coupons will change more
The FRN's price and coupons will change less than those of the fixed-rate bond
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