Floating-Rate Securities

Transcription

1 Floating-Rate Securities A floating-rate security, or floater, is a debt security whose coupon rate is reset at designated dates and is based on the value of a designated reference rate. - Handbook of Fixed Income Securities, 7 th Ed. CMTA Intermediate/Advanced Investment Workshop Floating-Rate Securities and Step-Up Bonds Tony Garcia, CFA January 28, 2015 Pomona, CA Floating-Rate Securities General Features The coupon formula for a floater without an embedded option can be expressed as follows: Coupon rate = reference rate ± quoted margin A floater will often impose a limit on how high the coupon rate can float, which is referred to as a cap. Common Reference Rates LIBOR (O/N, 1M, 3M, 6M) Treasury bills (1M, 3M, 6M) Constant Maturity Treasury (CMT) Prime rates Also, a floater will often specify a minimum coupon rate, which is referred to as a floor. Domestic CD rates When a floater possesses both a cap and a floor, the feature is referred to as a collar. Fed Funds (Effective, Open) Although a floater s coupon rate typically moves in the same direction as the reference rate, there are floaters whose coupon rates move in the opposite direction from the reference rate called inverse floaters (which are not legal for CA PEs) 3 1

2 Floating-Rate Securities Spread Measures Spread for Life Issuers Rate Resets Spread measures are used to gauge the return from holding a floater. Much like conventional fixed income securities, these measures are easy to calculate and interpret. However, they operate under simplifying assumptions (i.e. reference rates do not change), and ignore the presence of embedded options. - Handbook of Fixed Income Securities, 7th Ed. Spread for Life is a measure of the potential return that accounts for the accretion (amortization) of the discount (premium) as well as the constant index spread over the security s remaining life. Treasury Agencies Debentures and Asset Backed Securities Corporations Municipalities Reset dates typically correspond to the underlying index. I.e. 3-month LIBOR-index floaters typically resets every three months. However, floaters can reset at any interval specified in the documents. I.e. Fed funds floaters generally reset quarterly but could reset daily, weekly or monthly

3 Adjusted Simple Margin Adjusted Total Margin Discount Margin Adjusted Simple Margin is an adjustment to spread for life that accounts for the one time cost of carry effect when purchasing a floater with borrowed funds. Adjusted Total Margin is the adjusted simple margin plus the interest earned by investing the difference between the floaters par value and the carry-adjusted price. Discount Margin indicates the average spread over the reference rate that the investor can expect to earn over the security s life assuming the reference rate remains unchanged. Price Change = PV of change in DM

4 Floating-Rate Securities Components of Pricing Floating-Rate Securities Duration Summary and Example The price of a fixed income security changes when market rates fluctuate because the security s coupon rate differs from the prevailing rate for new comparable bonds issued at par. Since a floater s coupon resets periodically they are considered to be more defensive securities. Factors That Affect a Floater s Price Time to the next coupon date Change in the market s required margin (Basis Risk) Whether or not the cap or floor is reached Rationale Floaters that have a longer time to the next coupon reset date behave more like a fixed income security, thus having greater price fluctuations. Shorter resets outperform in a rising rate environment Longer resets outperform in a falling rate environment If the market requires a higher (lower) margin, the floater s price decreases (increases). The required margin depends on: The margin available in competitive funding markets Change in credit quality Presence of embedded options, and liquidity Floaters with a coupon rate that has risen above the cap will trade at a discount, while floaters with a coupon rate that has fallen below the floor will trade at a premium. If a floater s coupon rate does not float as the result of a cap or floor, it is essentially a standard fixed income security. One advantage of floating-rate securities is the fact that the presence of a coupon reset period offers an opportunity for investors to shorten the duration of their portfolio. Common Duration Measures for Floating-Rate Securities Index Duration measures a floater s price sensitivity to a change in the reference rate assuming the quoted margin is held constant. The interest rate risk for a floater is the reverse of a fixed-rate bond. As rates fall, floaters underperform. Prices remain close to par while fixed-rate bonds increase in value. As rates rise floaters outperform. Prices remain close to par while fixed-rate bonds decrease in price. Spread Duration measures a floater s price sensitivity to a change in the quoted margin (spread) assuming the reference rate is held constant. As credit risk views are adjusted, discount margin may shift, causing prices to shift. However, this is also reflected in the yield of a similar maturity fixed-rate bond. As credit risk views change, the longer the maturity the greater the change in DM. Lower Duration Reset frequency lowers effective duration Lower Price volatility Summary Yield will move in direction of underlying index Example: Toyota 1/17/19 vs. Treasury 1.25% 1/31/19 Toyota Motor Credit 1/17/19 Resets at 3 Month Libor +39 U. S. Treasury 1.25% 1/31/19 1/14/14 Toyota issued 1/14/14 at: Price: 100 DM: +39 Treasury 1.25% 1/31/19 was at: Price: Yield: 1.67% 1/20/15 Toyota DM: +32 Price: Treasury Yield: 1.28% Price: Change Toyota: DM declined 7 bps and price increased 0.28 Treasury: Yield declined 39 bps and price increased

5 What Is a Callable Bond? Variables Considered When Underwriting a New Security Step-Up Bonds The buyer of a callable is effectively long a bullet and short an option position Value of callable bond price = bullet price call option price Bonds get called when the coupon of a new bond is lower than the coupon of an outstanding issue Buyer of a callable should be compensated for selling the call option by receiving higher yields than matched maturity bullets Spread to Treasuries Spread to Matched Maturity Bullets Volatility GSE Funding Levels Customer Flows/Demand Economic Data Potential Supply (Daily Auctions ) If a Step-Up, Yield To Calls vs. Forward Curve Fill Gaps in Inventory

6 Volatility What Impacts Supply/Demand? GSE Funding Levels With an increase in volatility, callable spreads increase Spread widening decreases secondary market prices Wider spreads enhance yield Lower volatility decreases callable spreads Spreads tighten to bullets Value of secondary paper increase Short dated lockouts are greatly impacted by Fed policy When Fed policy is on hold, short dated volatility should be low which has been the case since the recession Rates Falling interest rates equals an increase in call activity Bonds Maturing As bonds roll off, they usually get replaced Increase in FHLB Advances The greater the demand for advances in the FHLB system, the greater the need for FHLB to access the callable, DN, and/or bullet market Portfolio Growth Callable issuance increases as FHLMC and FNMA s portfolio grows Future of FHLMC/FNMA? Called Bonds In a falling rate environment, investors replace called bonds with new issue paper Issuers adjust their funding levels on a daily basis for negotiated (swapped) structures Funding levels are quoted off of 3 ML Funding levels are determined by the needs of the issuer the greater the need the cheaper the funding Levels can fluctuate between length of lockout and call type Auction paper usually trades cheap to negotiated deals because the structure is driven by specific needs of the issuer and might not necessarily meet the needs of dealers and/or customers Spread to Bullets Customers buy callable bonds to get a pick up in yield over bullets and other asset classes. When callable spreads widen, customer demand increases Diversification Callable bonds add diversification to other asset classes as they offer flexibility in maturity and call type

7 OAS Settings Step Up Securities Comparison Fixed vs. Step-Up 5 Yr / 3 Mo Bermudan 5 Yr / 1 Yr Step Up Call features that are not 1x call, use the following industry standard inputs when calculating price on OAS1 page For 1x callable paper, use the following industry standard inputs when calculating price on AOAS page Volatility =14 Curve = I111 Volatility = Bloomberg Default Setting FNMA Curve = I252 FHLMC Curve = I267 Step up securities are all callable securities where the coupons increase on specific call dates Common Call Types Bermudan Quarterly Semi-Annual Annual One time callable only once on preset date Canary callable quarterly until a pre-specified date after which it is not callable (bullet) Verde callable on two or more dates (typically annually) after which it becomes non-callable Most Common Issuers GSEs Corporations Municipalities Yield Convention Typically Quoted as Internal Rate of Return synonymous with Yield to Maturity for Fixed Coupon Security

8 Comparison Continued Comparison Continued Step-Up Call and Coupon Schedules Fixed Coupon Step Up Fixed Coupon Step Up

9 Yield to Call Schedule Yield to Call Schedule Fixed Coupon vs. Step-Up Comparison Yield to Call & Wells Fargo Securities, LLC

10 Fixed Coupon vs. Step-Up Comparison It takes the step-up security a significant amount of time after passing its call date for the average yield to outperform the fixed-coupon callable. Forward Rate Curve Forward Rate Curve Coupons: 1.0% to 2 yr; 2.0% to 3 yr; 3.0% to 4 yr; 4.0% to 5 yr Yield to Call at: 1 yr 1.00%; 2 yr 1.00%; 3 yr 1.33%; 4 yr 1.73% ; 5 yr 2.17% Yield to Call & Wells Fargo Securities, LLC

11 Issuer s Future Interest Cost Liquidity: Fixed Coupon vs. Step -Ups Summary Probably the biggest advantage of a Step - Up is that it is more likely to be called than a Fixed coupon The issuers future interest cost increases over the life of a Step - Up Using our 5 yr / 1 yr Example: Yield to Call Fixed coupons have a stronger secondary market than step ups More active buyers for fixed coupons than step ups Many inherent variables in step-up bonds make it difficult for investors to determine value Each structure will tend to be somewhat unique making it difficult to compare issues Step-ups rarely trade at a premium Determine your maturity needs Cash Flow Needs Future Rate Expectations Relative Value is there a maturity range that is trading cheap on a spread basis compared to other maturities Call Frequency If you believe we are in a rising rate environment, look to shorter lockouts to maximize yield If you believe rates are going to fall, longer lockouts give you better yield protection Shorter locks could be viewed as money market alternatives Incremental yield pick up between American, Bermudan, and 1x calls Forward Curve For Step - Ups look at Yield To Call and Coupon structure compared to forward curve as this is a better representation than the advertised Internal Rate of Return & Wells Fargo Securities

12 Disclosure Appendix This communication is provided for informational purposes and should not be construed as a solicitation or offer to buy or sell any securities or related financial instruments. This analysis should be considered in the context of the risk characteristics of the instruments being compared, which may vary as to credit quality, marketability, reinvestment risk, and other factors. Prices and yields are subject to market changes and availability. Past performance is no guarantee of future results. Contact your investment representative, attorney, accountant or tax advisor with regard to your specific situation. Wells Fargo Securities is the trade name for the capital markets and investment banking services of Wells Fargo & Company and its subsidiaries, including but not limited to Wells Fargo Securities, LLC, a member of NYSE, FINRA, NFA and SIPC, Wells Fargo Institutional Securities, LLC, a member of FINRA and SIPC, Wells Fargo Prime Services, LLC, a member of FINRA, NFA and SIPC, and Wells Fargo Bank, N.A. Wells Fargo Securities, LLC carries and provides clearing services for Wells Fargo Institutional Securities, LLC customer accounts. Wells Fargo Securities, LLC, Wells Fargo Institutional Securities, LLC, and Wells Fargo Prime Services, LLC are distinct entities from affiliated banks and thrifts Wells Fargo Securities. All rights reserved