Yield and Yield Spread Measures for Floating-Rate Instruments

Prior lessons covered pricing, yields, and spreads for bonds with fixed coupon rates and times-to-maturity of one year or longer. The next two lessons broaden the discussion to include instruments with variable rather than fixed coupons, known as floating-rate instruments, and those with original maturities of one year or less, known as money market instruments. Both types of instrument are important for investors and issuers. Floating-rate instruments, by adjusting cash flows to changes in interest rates, bear less price risk than fixed-rate instruments and are used to hedge certain exposures and to match asset and liability cash flows. Most loans are floating-rate instruments. Money market instruments are a significant source of short-term financing for many types of issuers. A short time-to-maturity means that investors can reinvest and issuers can refinance relatively quickly, which reduces interest rate risk.

Most of the examples and exhibits used throughout the reading can be downloaded as a Microsoft Excel workbook. Each worksheet in the workbook is labeled with the corresponding example or exhibit number in the text.

• A floating-rate instrument is a debt instrument with interest determined by an observed market reference rate (MRR) plus a quoted margin. Interest payments are reset, capturing any change in the MRR, on predetermined dates.
• The quoted margin is a specified spread over or under the reference rate. The required margin, also known as the discount margin, is the spread required by investors.
• The required margin reflects “bottom-up” or issuer- and security-specific risks and is analogous to a yield spread for a fixed-rate bond discussed in prior lessons. If a floater trades at par, the quoted and required margins are equal. 
• Money market instruments have original maturities of one year or less and are quoted using different conventions from those of longer-dated securities. Quotes are made on a discount rate or add-on rate basis.
• Money market discount rates are interest income divided by the face value (maturity value). They understate the investor’s rate of return if the purchase price is below the face value and vice versa.
• Conventional money market measures can be converted to enhance comparability to longer-term securities.