Interest Rate Risk of Floating-rate Bonds
In case of fixed-rate bonds, the coupon is set as a reference rate plus a margin. Since the reference rates changes periodically, the coupon rate for the bond is also reset periodically, such as monthly, quarterly, or every six months. Every time the coupon is reset, the bond’s price also resets to par. However, the price of a floating-rate bond is not always the same and does very over time. Let’s look at the three key factors that could affect the price of such a bond.
Length of Time Between Coupon Reset Dates
Since coupon rates are not set every day, on a particular day the market interest rate could differ from the recently set coupon rate. Say for example, the coupon is reset every six months, and just after the day the coupon is reset, the market interest rate changes. So, for the next 179 days, the coupon rate will be different from the market rate, which will affect the price of the bond. If the market rate is higher than the coupon rate, the bond price will decline and vice versa. A bond with shorter reset dates will be less price sensitive compared to a bond with longer reset dates.
Change in Margin Required by the Investor
As we mentioned above, the coupon of a floating-rate bond is set as reference rate + a margin. The margin reflects risk taken by the investor compared to a risk-free bond, such as credit risk and liquidity risk. It could be so that the market conditions have changed and the investor now demands a higher margin for the same bond. This will also increase the expected yield of the investor and inversely affect the price.
Cap Rate in the Bond
The floating rate of the bond may be capped, and if the market interest rates rise above this rate, the bond’s coupon rate will be capped to this rate. In this scenario again, the market interest rate will become higher than the coupon rate and lower the price of the bond.
To conclude, while measuring the interest rate risk in a floating-rate bond, all the above factors should be considered.
- Bond Duration and Convexity Simplified – Part 1 of 2
- Bond Duration and Convexity Simplified – Part 2 of 2
- Key Risks Associated with Investing in Bonds
- Understanding Inverse Price/Yield Relationship in Bonds
- Bond Features Affecting Interest Rate Risk
- Impact of Yield Level on Bond’s Price Sensitivity
- Price of a Callable Bond
- Interest Rate Risk of Floating-rate Bonds
- Yield Curve Risk
- Call and Prepayment Risk
- Reinvestment Risk in Bonds
- Credit Risk in Bonds
- Liquidity Risk in Bonds
- Exchange Rate Risk in Bonds
- Inflation Risk in Bonds
- Volatility Risk in Bonds with Embedded Options
- Event Risk and Sovereign Risk in Bonds