I came across a question in reading 54 (#25 actually) that mentions a case where a floating rate security wouldn’t return to par based on margin required by investors…can someone explain this?
If I were to buy a bond that paid a floating interest rate with $100 par value (assuming there are no provisions or default) why wouldn’t the institution that sold me that bond not pay me back the $100 at expiration?
Floating rate bonds typically have a CAP on the coupon rate.
The coupon rate of a floating rate bond is calculated by a reference rate + a fixed margin.
This coupon rate is reset on particular reset dates
If the market interest rate (or the refeerence rate) increases, then during the reset date the necessary change in coupon rate would be made. This reset would happen until the market rate equals the cap rate.
Once the coupon rate calculate throught the formula exceeds the cap rate, the coupon rate of the bond would be fixed at cap rate.
But this cap rate (coupon rate) is lesser than what the investors are demanding in the market. Hence the price of this particular bond falls as market interest rates rise.
I get the fact that during the life of the bond there can be great discrepancies between the price of the bond and par (especially if there is a cap) but just like an out of the option at expiration tending to zero, why wouldn’t that be the same for a bond as the par value is what is to be paid?
For example, If I were to buy (or sell) a bond that was going to expire in 5 minutes with face value $100, isn’t it logical to assume that the price would be 100 no matter what the prevailing interest rate is?
There are two things u need to consider for this question…
Market Interest rate - Say the market interest rate goes above the coupon rate ( e.g. Market rate - 11%, Coupon - 9%)
Price Cap - Say this bond has a cap rate 9%.So even if interest rate goes above 9%, coupon will contiue to be 9%
So this particular bond is offering a rate lesser than the prevailing interest rate. Prevailing interest rate is the rate that investors require. Since this particular bond is offering a rate lesser than what they demand, hence the demand for this bond would go down and therefore investors would pay lesser for this bond.
Thus the price would be lesser because of the unattractiveness of the bond