Inverse floating rate note
Encyclopedia
An inverse floating rate note, or simply an inverse floater, is a type of bond
or other type of debt instrument used in finance whose coupon rate
has an inverse relationship to short-term interest rates (or its reference rate
). With an inverse floater, as interest rates rise the coupon rate falls. The basic structure is the same as an ordinary floating rate note
except for the direction in which the coupon rate is adjusted. These two structures are often used in concert.
As short-term interest rates fall, both the market price
and the yield
of the inverse floater increase. This link often magnifies the fluctuation in the bond's price. However, in the opposite situation, when short-term interest rates rise, the value of the bond can drop significantly, and holders of this type of instrument may end up with a security that pays little interest and for which the market will pay very little. Thus, interest rate risk
is magnified and contains a high degree of volatility.
fixed-rate security into a trust
and issuing both a floating rate note and an inverse floating rate note. The second method is for an investment banking firm to underwrite a fixed-rate security and then enter into an interest rate swap
that has a maturity less than the bond's term. The investor would then own an inverse floater until the swap agreement expires. When creating an inverse floater through the swap market the need to sell in inverse floaters through a Dutch auction
is eliminated. In the first scenario the original security placed in trust is referred to as the collateral
, from this collateral both the floater and inverse floater are created. The dealer will split up the underlying fixed-rate asset at a specified ratio (e.g. 20/80) and assign each portion to inverse and floater.
The reference rate and the frequency at which the rate is reset are contractually set. The rate used is often some form of LIBOR, but it can take different forms, such as tying it to the consumer price index
, a housing price index, or an unemployment rate. The rate can be allowed to reset on an immediate, daily, or some type of monthly or yearly schedule. The rate can be computed by taking its set stated rate and subtracting the reference rate at the reset date. Caps and floors
are often placed within inverse floaters to avoid unattractive features to investors (such as a negative coupon). Typically, the floor is set at zero and a cap may be set (e.g. 10%). If a floater is involved a cap is put on the floater to match up with the inverse's floor, and vice versa. This is done since both are derived from the same fixed-rate asset.
(CMO), municipal
, and corporate
markets.
and analyze, and is usually sold to sophisticated investors. The collateral in this market refers to mortgage-related products which create the CMO, this is known as "CMO collateral." The fixed-rate asset, or tranche
, is used to create the floater and inverse floater is known as the "tranche collateral."
and combine the two positions to essentially own the underlying asset. The investor can elect to split the issue again and retain the inverse floater portion. This option can be valuable to investors, but generally carries less yield than a comparable fixed-rate bond that does not carry this option. The ratio of floaters to inverse floaters is usually 50/50.
, which mean that they are part of an underlying swap transaction.
. To illustrate, suppose the creator of the floater and inverse floater divides the underlying collateral up into 100 bonds, 20 inverse an 80 floater bonds.
The leverage
in this structure is 4:1 of floater to inverse bonds. As such the following relationship must hold:
Based on this formula and value of the collateral, it can not be assumed that a decrease in the reference rate
will automatically translate into a gain for the inverse floater. Such scenarios can be attributed to changes in the overall market and the yield curve
that negatively impact the collateral's value.
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
or other type of debt instrument used in finance whose coupon rate
Coupon (bond)
A coupon payment on a bond is a periodic interest payment that the bondholder receives during the time between when the bond is issued and when it matures. Coupons are normally described in terms of the coupon rate, which is calculated by adding the total amount of coupons paid per year and...
has an inverse relationship to short-term interest rates (or its reference rate
Reference rate
A reference rate is a rate that determines pay-offs in a financial contract and that is outside the control of the parties to the contract. It is often some form of LIBOR rate, but it can take many forms, such as a consumer price index, a house price index or an unemployment rate...
). With an inverse floater, as interest rates rise the coupon rate falls. The basic structure is the same as an ordinary floating rate note
Floating rate note
Floating rate notes are bonds that have a variable coupon, equal to a money market reference rate, like LIBOR or federal funds rate, plus a spread. The spread is a rate that remains constant. Almost all FRNs have quarterly coupons, i.e. they pay out interest every three months, though counter...
except for the direction in which the coupon rate is adjusted. These two structures are often used in concert.
As short-term interest rates fall, both the market price
Market price
In economics, market price is the economic price for which a good or service is offered in the marketplace. It is of interest mainly in the study of microeconomics...
and the yield
Yield (finance)
In finance, the term yield describes the amount in cash that returns to the owners of a security. Normally it does not include the price variations, at the difference of the total return...
of the inverse floater increase. This link often magnifies the fluctuation in the bond's price. However, in the opposite situation, when short-term interest rates rise, the value of the bond can drop significantly, and holders of this type of instrument may end up with a security that pays little interest and for which the market will pay very little. Thus, interest rate risk
Interest rate risk
Interest rate risk is the risk borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa...
is magnified and contains a high degree of volatility.
Creation
An inverse floating rate note can be created two ways. The first is by placing an existing or newly underwrittenUnderwriting
Underwriting refers to the process that a large financial service provider uses to assess the eligibility of a customer to receive their products . The name derives from the Lloyd's of London insurance market...
fixed-rate security into a trust
Escrow
An escrow is:* an arrangement made under contractual provisions between transacting parties, whereby an independent trusted third party receives and disburses money and/or documents for the transacting parties, with the timing of such disbursement by the third party dependent on the fulfillment of...
and issuing both a floating rate note and an inverse floating rate note. The second method is for an investment banking firm to underwrite a fixed-rate security and then enter into an interest rate swap
Interest rate swap
An interest rate swap is a popular and highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate or from one floating rate to another...
that has a maturity less than the bond's term. The investor would then own an inverse floater until the swap agreement expires. When creating an inverse floater through the swap market the need to sell in inverse floaters through a Dutch auction
Dutch auction
A Dutch auction is a type of auction where the auctioneer begins with a high asking price which is lowered until some participant is willing to accept the auctioneer's price, or a predetermined reserve price is reached. The winning participant pays the last announced price...
is eliminated. In the first scenario the original security placed in trust is referred to as the collateral
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
, from this collateral both the floater and inverse floater are created. The dealer will split up the underlying fixed-rate asset at a specified ratio (e.g. 20/80) and assign each portion to inverse and floater.
The reference rate and the frequency at which the rate is reset are contractually set. The rate used is often some form of LIBOR, but it can take different forms, such as tying it to the consumer price index
Consumer price index
A consumer price index measures changes in the price level of consumer goods and services purchased by households. The CPI, in the United States is defined by the Bureau of Labor Statistics as "a measure of the average change over time in the prices paid by urban consumers for a market basket of...
, a housing price index, or an unemployment rate. The rate can be allowed to reset on an immediate, daily, or some type of monthly or yearly schedule. The rate can be computed by taking its set stated rate and subtracting the reference rate at the reset date. Caps and floors
Interest rate cap and floor
An interest rate cap is a derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price...
are often placed within inverse floaters to avoid unattractive features to investors (such as a negative coupon). Typically, the floor is set at zero and a cap may be set (e.g. 10%). If a floater is involved a cap is put on the floater to match up with the inverse's floor, and vice versa. This is done since both are derived from the same fixed-rate asset.
Issuers
Inverse floaters are issued in the collateralized mortgage obligationCollateralized mortgage obligation
A collateralized mortgage obligation is a type of financial debt vehicle that was first created in 1983 by the investment banks Salomon Brothers and First Boston for U.S. mortgage lender Freddie Mac. A collateralized mortgage obligation (CMO) is a type of financial debt vehicle that was first...
(CMO), municipal
Municipal bond
A municipal bond is a bond issued by a city or other local government, or their agencies. Potential issuers of municipal bonds includes cities, counties, redevelopment agencies, special-purpose districts, school districts, public utility districts, publicly owned airports and seaports, and any...
, and corporate
Corporate bond
A corporate bond is a bond issued by a corporation. It is a bond that a corporation issues to raise money in order to expand its business. The term is usually applied to longer-term debt instruments, generally with a maturity date falling at least a year after their issue date...
markets.
CMO
The CMO market is the largest issuer of inverse floaters. The CMO inverse floater is considered a more complicated instrument to hedgeHedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...
and analyze, and is usually sold to sophisticated investors. The collateral in this market refers to mortgage-related products which create the CMO, this is known as "CMO collateral." The fixed-rate asset, or tranche
Tranche
In structured finance, a tranche is one of a number of related securities offered as part of the same transaction. The word tranche is French for slice, section, series, or portion, and is cognate to English trench . In the financial sense of the word, each bond is a different slice of the deal's...
, is used to create the floater and inverse floater is known as the "tranche collateral."
Municipal
In the municipal market, the investor of an inverse floater can purchase the corresponding floater at an auctionAuction
An auction is a process of buying and selling goods or services by offering them up for bid, taking bids, and then selling the item to the highest bidder...
and combine the two positions to essentially own the underlying asset. The investor can elect to split the issue again and retain the inverse floater portion. This option can be valuable to investors, but generally carries less yield than a comparable fixed-rate bond that does not carry this option. The ratio of floaters to inverse floaters is usually 50/50.
Corporate
Almost all corporate inverse floaters are issued as structured notesStructured product
In finance, a structured product, also known as a market linked investment, is generally a pre-packaged investment strategy based on derivatives, such as a single security, a basket of securities, options, indices, commodities, debt issuance and/or foreign currencies, and to a lesser extent, swaps...
, which mean that they are part of an underlying swap transaction.
Leverage and valuation
Additional valuation of an inverse floater can be determined by looking at the security's coupon leverageCoupon leverage
Coupon leverage, or leverage factor, is the amount by which a reference rate is multiplied to determine the floating interest rate payable by an inverse floater...
. To illustrate, suppose the creator of the floater and inverse floater divides the underlying collateral up into 100 bonds, 20 inverse an 80 floater bonds.
The leverage
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
in this structure is 4:1 of floater to inverse bonds. As such the following relationship must hold:
Based on this formula and value of the collateral, it can not be assumed that a decrease in the reference rate
Reference rate
A reference rate is a rate that determines pay-offs in a financial contract and that is outside the control of the parties to the contract. It is often some form of LIBOR rate, but it can take many forms, such as a consumer price index, a house price index or an unemployment rate...
will automatically translate into a gain for the inverse floater. Such scenarios can be attributed to changes in the overall market and the yield curve
Yield curve
In finance, the yield curve is the relation between the interest rate and the time to maturity, known as the "term", of the debt for a given borrower in a given currency. For example, the U.S. dollar interest rates paid on U.S...
that negatively impact the collateral's value.
See also
- Auction rate securityAuction Rate SecurityAn auction rate security typically refers to a debt instrument with a long-term nominal maturity for which the interest rate is regularly reset through a dutch auction. Since February 2008, most such auctions have failed, and the auction market has been largely frozen...
- Collateralized debt obligationCollateralized debt obligationCollateralized debt obligations are a type of structured asset-backed security with multiple "tranches" that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand...
- Float (finance)
- Inflation-indexed bondInflation-indexed bondInflation-indexed bonds are bonds where the principal is indexed to inflation. They are thus designed to cut out the inflation risk of an investment. The first known inflation-indexed bond was issued by the Massachusetts Bay Company in 1780...