A floating coupon bond is a type of bond. In this, the payment of the periodic interest (coupon) depends on a reference interest rate, previously set. Also known in English as floating-rate note -FRN – or floater.
These types of bonds are usually used to immunize portfolios from interest rate risk or, on the other hand, to reduce the duration of fixed income portfolios. It is similar to hedging a fixed rate bond with a swap (since when you buy a swap you pay a fixed rate and receive a variable one). To do this, a variable interest bond is purchased.
Characteristics of the bonus with floating coupons
The vast majority of European securities are in the variable rate bond format.
The reference interest rate of the variable interest bond (hereinafter FRN) is usually a money market interest rate (Euribor or Libor). In most FRNs they pay the reference rate plus an interest rate in the form of a margin. This margin is expressed in basis points expressed in hundreds of as much per 1%. For example, the spread of 120 basis points equals 1.2%.
For example, we consider a variable interest bond that pays the Euribor plus a margin of 0.75% (75 basis points) annually. If the 1-year Euribor is 2.3% at the beginning of the year, the bond will pay 2.3% + 0.75% = 3.05% of its face value at the end of the year. The following 1-year interest rate reference will be updated and will determine the rate to be paid at the end of the following year.
Many of these bonds are referenced in a quarterly payment, the reference being the 90-day rate (90/3 = 30 days), having three quarters a year (3 × 4 = 12), and therefore revisions.
There may be the condition that the coupon of the bond increases when the reference rate decreases, then we would be talking about a bond with inverse variable interest (in English inverse floater ).
A defining characteristic of these bonds is that they are more stable compared to those with a fixed coupon (the most common and traditional), under the same maturity conditions. This is because the interest rate is periodically reviewable (it will depend on the chosen reference rate), and therefore they fluctuate with the reference interest rate.
How is the coupon of a bond with floating coupons calculated?
The coupon for an FRN as we mentioned is:
Coupon = Reference interest rate +/- margin
This margin will depend on the credit risk of the bond in relation to the credit risk of the reference rate.
If the FRN bond is issued by a company that has a higher (lower) credit risk than banks that quote the reference interest rate (Euribor, Libor, etc.), a margin will be added (subtracted).
Terminology in an FRN
- Margin: It is the margin that is added or subtracted from the reference interest rate.
- Discount margin: It is the margin required to return the bond at its face value (at par).
When the credit quality remains unchanged, and the discount margin is equal, then the FRN returns to its nominal value at each review (periodicity according to the reference rate used), when the next coupon payment is "reset" to the interest rate. current market rate (plus or minus the margin).
When the issuer’s credit quality declines, the margin will be less than the discount margin and the FRN will trade below its nominal value. Whereas, if the quality of the issuer improves, then the margin will be greater than the discount margin, trading above its nominal value.