05 May 2011

Fixed Income Research

http://www.credit-suisse.com/researchandanalytics

European Credit Views

Contributors
Chiraag Somaia
+44 20 7888 2776
[email protected]

A Compact Guide to Floating Rate Notes

We provide a broad yet detailed overview of the Floating Rate Note (FRN)
market. In the Introduction, we look at historical issuance trends and
distributions across FRN markets, both corporate and financial, as well as euroand USD-denominated.
The Structure section then sets out the basic components of an FRN, with
particular focus being given to the indices underlying them as well as to the
various coupon conventions.
In Valuation & Analytics, we cover a key measure in the FRN space the
discount margin and also shed light on the various price sensitivities an FRN
security exhibits.
The Trading section covers how to compare different FRNs, and also provides
methods for evaluating relative value between FRNs and their fixed rate
counterparts.
Finally, in Extensions, we explore callable FRN securities and also examine
FRNs in the high yield space.

ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES ARE IN THE DISCLOSURE APPENDIX. FOR OTHER
IMPORTANT DISCLOSURES, PLEASE REFER TO https://firesearchdisclosure.credit-suisse.com.

05 May 2011

European Credit Views

Introduction

Structure

Valuation & Analytics

Trading

Extensions

05 May 2011

Introduction
A Floating Rate Note (FRN) is a bond that has a variable coupon, where each coupon
payment is linked to the prevailing level of an underlying index, e.g. 3-month EURIBOR.
The variable coupons mean FRNs are notably less sensitive to interest rate moves than
their fixed rate counterparts.
FRN securities were first introduced into the European market in the early 1970s. They
were brought to the US soon afterwards, but it was only in the 1980s when demand
increased significantly as interest rates moved higher and became more volatile
conditions where FRNs provided better protection against price volatility for bond investors.
FRNs provide portfolio managers yield whilst allowing them to maintain a low duration.
They have also typically been bought by financial institutions with floating rate liabilities as
well as money market funds that use them as an alternative to other short-term
investments (e.g., commercial paper, repos, etc.).

Exhibit 1: Historical FRN and fixed rate debt issuance (split by currency and sector)
Issuance in EUR billion

Source: Credit Suisse, Dealogic

Since 1999, the euro-denominated FRN market has been dominated by financial issuers
(Exhibit 1). Average yearly FRN issuance by financials has been EUR 172 billion, whilst
only EUR 24 billion for corporates. It is a similar but slightly less asymmetric story in the
US where issuance levels have been EUR 131 billion (financials) and EUR 30 billion
(corporates). FRNs also make up a higher proportion of total (fixed + floating) issuance for
financials than corporates.

European Credit Views

05 May 2011

As the euro FRN market is slightly larger than its USD counterpart for financials, and the
total (fixed + floating) issuance levels seen in both markets is similar, the dependency on
FRN financing is thus higher in the euro market. For corporates, the USD FRN market is
bigger than its euro equivalent, but the large size of the fixed USD market means that euro
FRNs again comprise a greater percentage of total debt issuance.
For the period shown in Exhibit 1, relative levels of FRN issuance peaked in 2004-2006.
Since then, as the financial crisis took shape and interest rate expectations peaked, both
absolute and relative FRN issuance amounts tailed off significantly, as investors moved to
lock in high fixed-rate coupons on offer. With easy monetary policy conditions following
since, demand for FRNs has become subdued and issuance levels remain very low as
issuers take advantage of interest rate conditions to lock in low rates for long periods.
FRN issuance tends to be short-dated. Looking back at issuance from 2006, 72% and
85% of issuance came between the 2- and 5-year maturity buckets for the euro and USD
markets, respectively (Exhibit 2). As issuance dropped substantially during the financial
crisis, this bias towards shorter maturities became even more pronounced. In 2010, 80%
and 85% of issuance came in the 2- and 3-year maturity buckets for the euro and USD
markets, respectively.

Exhibit 2: Distribution of FRN issuance in 2006 and 2010 by maturity bucket

Source: Credit Suisse, Dealogic

European Credit Views

05 May 2011

Structure
The essential feature of an FRN is that its coupon payments are tied to an underlying
index. The FRN coupon is reset periodically, referencing this index. The reset frequency,
payment frequency, day count convention and initial margin all provide variation in the
FRN market. We refer to an uncapped (coupons can be capped), unfloored, bullet format
floating rate security as a pure floater. In Exhibit 3, we show example terms of a pure
floater for a recently issued FRN.

Exhibit 3: Example terms for a pure floater

Issuer
Time to Maturity
Index
Initial Margin

AA-rated Bank
2 years
3-month EURIBOR
+145

Reset Frequency

Quarterly

Payment Frequency

Quarterly

Day Count Convention

Coupon Rate

ACT/360
3-month EURIBOR + 145

Source: Credit Suisse, the BLOOMBERG PROFESSIONAL service

Indices: Comparable FRNs (but with differing underlying indices) can change in price
relative to one another when the spread differential between the two underlying indices
changes. In the euro market, 3-month EURIBOR is the most popular. In 2010, 90% of euro
FRN issuance was tied to this index. A small proportion is tied to other indices, including
other parts of the EURIBOR curve (1-, 6-, and 12-month) and Constant Maturity Swap
(CMS) rates. In the USD market, there is a similarly heavy reliance (88% of 2010
issuance) on one index in this case, 3-month USD LIBOR. Of the remaining issuance,
other parts of the USD LIBOR curve, CMS rates and Constant Maturity Treasury (CMT)
rates are used. Given the dominance of three-month indices across both markets, the bulk
of liquidity in the FRN market is largely for bonds with these underlying indices.
Initial Margin: Along with the underlying index, the margin determines the current and
future coupons of an FRN. Most FRNs have their coupons reset at a fixed spread over the
index level. This spread is referred to as the initial margin and is determined by the credit
quality of the issuer, the maturity of the FRN and prevailing market conditions. In Exhibit 3,
the initial margin is 145 basis points for the AA-rated bank. A lower quality issuer would
likely have a higher initial margin (to compensate the investor for holding the extra credit
risk).
Coupon Reset/Payment Frequency: The coupon reset frequency of an FRN affects its
price volatility as it determines the length of time for which the coupon can differ from
prevailing market interest rates. The reset frequency is a function of the underlying index
itself, so an FRN based on say 3-month EURIBOR will have a quarterly resetting schedule.
In times of rising rates, more frequently resetting coupons are usually favoured by market
participants as they tend to capture rate increases sooner. The opposite is true in an
environment of falling rates. The payment frequency of an FRN coupon is also usually a
function of the underlying index.
Day Count Convention: The ACT/360 convention is the most popular for euro- and USDdenominated FRNs. For GBP-denominated notes, the usual convention is ACT/365
instead.

European Credit Views

05 May 2011

Valuation & Analytics

Since FRNs do not have known cash flows, the traditional yield measures used for fixed
rate debt are not as useful. The most frequently used measure is instead the discount
margin. In the below analysis, we look at this measure in the context of a pure floater (as
described in the previous section).
The Discount Margin (DM) is the spread over and above the reference index that ensures
the present value of the expected future cash flows is equal to the market price of the FRN.
n

P=
i =1

ci
I1 + DM d1 d s i I j + DM
1 +
1 +

360 j =2 100
100

dj

360

where,
P

= FRN price + accrued interest

ci

= cash flow received at end of period i (including principal at end of period n)

Ii

= assumed index level during period i

I1

= current value of index level

di

= number of actual days in period i (assuming ACT/360 convention)

ds = number of days from start of period to settlement date

DM = discount margin
Since all coupon payments (except for the first) are unknown, the second and future cash
flows have to be estimated in order to calculate the DM of an FRN. The convention is to use
the spot underlying index value as the assumed rate for the second and future index fixings.
The DM is quoted with the same compounding frequency as the payments, e.g., quarterly
pay FRNs have DMs quoted in quarterly yield. As a result, in order to make a comparison
between two FRNs using the DM measure, it is clear that this will only be meaningful if both
securities have the same underlying index rate and the same coupon payment frequency.
Duration is a measure of a securitys price sensitivity to changes in yield. For FRNs, the yield
can be determined by looking at both the underlying index level and the DM. Thus to determine
the duration of an FRN, we need to look at price sensitivity with respect to changes in the
underlying index level (Index Duration) and changes in the DM (Spread Duration).
Index Duration is approximately equal to the time until the next coupon reset. Spread
duration is approximately equal to the modified duration of a fixed rate bond with the same
coupon and maturity as the FRN. Thus FRNs generally have low index duration (the interest
rate risk element) whereas they can exhibit high spread duration (the credit risk element).
Finally, in a discussion of FRN price sensitivity, it is important to mention that although
FRNs have low index duration, price volatility can occur as a result of other factors, such
as: 1) issuer credit quality, 2) index, 3) time to maturity, and 4) coupon reset frequency.
The issuers credit quality is chief amongst these factors at issuance, the initial margin is
usually set to price the FRN at par, so subsequent changes in the issuers credit quality
will impact the price of the FRN. The choice of underlying index and coupon reset
frequency both impact FRN prices, which was discussed in greater detail in the previous
section. Time to maturity also impacts price sensitivity. Consider a deterioration in issuer
credit quality such that a below market coupon is being paid by an FRN. The longer an
investor has to receive such a coupon, i.e., the longer the maturity of the FRN, the more
the FRN price will decline.

European Credit Views

05 May 2011

Trading
In comparing two FRNs, the metric of choice is typically the Discount Margin (DM). As
mentioned in the previous section, in order to compare two FRNs with this measure, both
securities should have the same underlying index and coupon payment frequency. In
comparing the richness or cheapness of an FRN with all other FRNs along the same
issuer curve, the analysis is much the same as when comparing fixed rate bonds, but
instead of looking at spreads, we look at the DM of each FRN.
In comparing an FRN to a fixed rate bond, one method is to compare the DM of the FRN
with the asset swap spread of the fixed rate bond. Given the convention for eurodenominated interest rate swaps to use 6-month EURIBOR on the floating leg, we would
also have to factor in the 3-month versus 6-month EURIBOR basis swap level in order to
compare the asset swap level with a euro FRN that has its DM quoted on a quarterly basis.
Note the DM calculation assumes the underlying index fixings for the second and future
cash flows is the same as the spot index level, which is not ideal in a world of rising (or
falling) interest rates nor in a world of volatile interest rates.
Another method for comparing FRNs to fixed rate bonds takes account of these various
interest rate scenarios. We can instead overlay the FRN with an interest rate swap such
that the floating rate coupons of the FRN are exactly matched by the floating leg of the
swap. Then the fixed rate that provides such floating cash flows on the swap can be used
to derive a yield measure that can be compared to the yield of the fixed rate bond. The
YASN <GO> page in Bloomberg has this functionality, where the derived yield is referred
to as a fixed equivalent yield. In Exhibit 4, the fixed equivalent yield to maturity (the upper
highlighted circle) of the Santander euro September 2013 FRN is 3.5918%. To illustrate
the significance of this number, this compares to a DM of 140.8 basis points, which is
calculated based on the spot 3-month EURIBOR level of 1.3750% to give a yield of
1.408% + 1.3750% = 2.7830% instead (the lower highlighted circle).

Exhibit 4: Comparing FRNs with fixed rate bonds using Bloomberg

The YASN <GO> page in Bloomberg can be used to calculate an alternative FRN yield that can be better compared to a
fixed rate bond yield. See above text for more details.

Source: Credit Suisse, the BLOOMBERG PROFESSIONAL service

European Credit Views

05 May 2011

Extensions
Callable FRNs: The analysis of callable FRNs versus callable fixed rate debt differs
notably. Whereas the focus in the valuation of a call option on fixed rate debt is the change
in interest rates, the important factor in valuing the option in the case of an FRN is the
change in issuer credit spread. For example, an FRN previously issued with a coupon of
3-month EURIBOR + 200 basis points is very likely to be called if the issuer can now issue
a new FRN at 3-month EURIBOR + 100 basis points.
In an environment of relatively tight credit spreads, callable FRNs previously issued at
higher spreads to the underlying index are likely to be called. They therefore trade to their
call date and thus provide investors who believe spreads will not widen substantially with
an opportunity to pick up additional yield.
Issuance of callable FRNs has tailed off along with the rest of the FRN market over the
past few years (Exhibit 5). Note the increasing issuance trend (both absolute and relative)
during the previous interest rate hiking cycle from the ECB and the Fed.

Exhibit 5: A similar pattern to the rest of the market callable FRN issuance
Euro-denominated and USD-denominated callable FRN issuance in EUR billion

100

16%

90

14%

80

12%

70
60

10%

50

8%

40

6%

30

Callable FRN Issuance

Callable % of FRN Market [RHS]

4%

20

2010

2009

2008

2007

2006

2005

2004

2003

2002

0%
2001

0
2000

2%
1999

10

Source: Credit Suisse, Dealogic

High Yield FRNs: Despite the record issuance levels seen in the high yield market last
year (EUR 214 billion across euro-denominated and USD-denominated issues), the high
yield FRN market saw next to nothing in terms of issuance (EUR 668 million). In general,
the market for high yield FRNs exhibits similar issuance trends to other parts of the FRN
market in that issuance was largest during the 2004-2007 period.
Issuance of high yield FRNs so far in 2011 seems to show that demand for these bonds is
returning EUR 3.4 billion of deals have priced this year, which is significantly more than
the combined issuance seen between 2008 and 2010, and is also the largest issuance
year since 2000 outside of the 2004-2007 period.

European Credit Views

Credit Strategy and Quantitative Research

William Porter, Managing Director

Group Head
+44 20 7888 1207
[email protected]
Helen Haworth, CFA, Director

Christian Schwarz, Vice President

+44 20 7888 0757

[email protected]

+44 20 7888 3161

[email protected]

Chiraag Somaia, Associate

Joachim Edery, Analyst

+44 20 7888 2776

[email protected]

+44 20 7888 7382

[email protected]

Disclosure Appendix
Analyst Certification
I, Chiraag Somaia, certify that (1) the views expressed in this report accurately reflect my personal views about all of the subject companies and securities
and (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report.
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Emerging Markets Bond Recommendation Definitions
Buy: Indicates a recommended buy on our expectation that the issue will deliver a return higher than the risk-free rate.
Sell: Indicates a recommended sell on our expectation that the issue will deliver a return lower than the risk-free rate.
Corporate Bond Fundamental Recommendation Definitions
Buy: Indicates a recommended buy on our expectation that the issue will be a top performer in its sector.
Outperform: Indicates an above-average total return performer within its sector. Bonds in this category have stable or improving credit profiles and are
undervalued, or they may be weaker credits that, we believe, are cheap relative to the sector and are expected to outperform on a total-return basis. These
bonds may possess price risk in a volatile environment.
Market Perform: Indicates a bond that is expected to return average performance in its sector.
Underperform: Indicates a below-average total-return performer within its sector. Bonds in this category have weak or worsening credit trends, or they may
be stable credits that, we believe, are overvalued or rich relative to the sector.
Sell: Indicates a recommended sell on the expectation that the issue will be among the poor performers in its sector.
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Corporate Bond Risk Category Definitions
In addition to the recommendation, each issue may have a risk category indicating that it is an appropriate holding for an "average" high yield investor,
designated as Market, or that it has a higher or lower risk profile, designated as Speculative and Conservative, respectively.
Credit Suisse Credit Rating Definitions
Credit Suisse may assign rating opinions to investment-grade and crossover issuers. Ratings are based on our assessment of a company's creditworthiness
and are not recommendations to buy or sell a security. The ratings scale (AAA, AA, A, BBB, BB, B) is dependent on our assessment of an issuer's ability to
meet its financial commitments in a timely manner. Within each category, creditworthiness is further detailed with a scale of High, Mid, or Low with High
being the strongest sub-category rating: High AAA, Mid AAA, Low AAA obligor's capacity to meet its financial commitments is extremely strong; High
AA, Mid AA, Low AA obligor's capacity to meet its financial commitments is very strong; High A, Mid A, Low A obligor's capacity to meet its financial
commitments is strong; High BBB, Mid BBB, Low BBB obligor's capacity to meet its financial commitments is adequate, but adverse
economic/operating/financial circumstances are more likely to lead to a weakened capacity to meet its obligations; High BB, Mid BB, Low BB obligations
have speculative characteristics and are subject to substantial credit risk; High B, Mid B, Low B obligor's capacity to meet its financial commitments is
very weak and highly vulnerable to adverse economic, operating, and financial circumstances; High CCC, Mid CCC, Low CCC obligor's capacity to meet
its financial commitments is extremely weak and is dependent on favorable economic, operating, and financial circumstances. Credit Suisse's rating opinions
do not necessarily correlate with those of the rating agencies.

Credit Suisses Distribution of Global Credit Research Recommendations* (and Banking Clients)
Global Recommendation Distribution**
Buy

4%

(of which 92% are banking clients)

Outperform

35%

(of which 95% are banking clients)

Market Perform

45%

(of which 95% are banking clients)

Underperform

15%

(of which 89% are banking clients)

Sell

<1%

(of which 67% are banking clients)

*Data are as at the end of the previous calendar quarter.

**Percentages do not include securities on the firms Restricted List and might not total 100% as a result of rounding.

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from jurisdiction to jurisdiction and may require that the trade be made in accordance with applicable exemptions from registration or licensing requirements. Non-U.S. customers wishing
to effect a transaction should contact a CS entity in their local jurisdiction unless governing law permits otherwise. U.S. customers wishing to effect a transaction should do so only by
contacting a representative at Credit Suisse Securities (USA) LLC in the U.S.
This material is not for distribution to retail clients and is directed exclusively at Credit Suisse's market professional and institutional clients. Recipients who are not market professional or
institutional investor clients of CS should seek the advice of their independent financial advisor prior to taking any investment decision based on this report or for any necessary explanation
of its contents. This research may relate to investments or services of a person outside of the UK or to other matters which are not regulated by the FSA or in respect of which the
protections of the FSA for private customers and/or the UK compensation scheme may not be available, and further details as to where this may be the case are available upon request in
respect of this report.
CS may provide various services to US municipal entities or obligated persons ("municipalities"), including suggesting individual transactions or trades and entering into such transactions.
Any services CS provides to municipalities are not viewed as advice within the meaning of Section 975 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. CS is
providing any such services and related information solely on an arms length basis and not as an advisor or fiduciary to the municipality. In connection with the provision of the any such
services, there is no agreement, direct or indirect, between any municipality (including the officials, management, employees or agents thereof) and CS for CS to provide advice to the
municipality. Municipalities should consult with their financial, accounting and legal advisors regarding any such services provided by CS. In addition, CS is not acting for direct or indirect
compensation to solicit the municipality on behalf of an unaffiliated broker, dealer, municipal securities dealer, municipal advisor, or investment adviser for the purpose of obtaining or
retaining an engagement by the municipality for or in connection with Municipal Financial Products, the issuance of municipal securities, or of an investment adviser to provide investment
advisory services to or on behalf of the municipality.
Copyright 2011 CREDIT SUISSE GROUP AG and/or its affiliates. All rights reserved.

Investment principal on bonds can be eroded depending on sale price or market price. In addition, there are bonds on which
investment principal can be eroded due to changes in redemption amounts. Care is required when investing in such instruments.

When you purchase non-listed Japanese fixed income securities (Japanese government bonds, Japanese municipal bonds, Japanese government guaranteed bonds, Japanese corporate
bonds) from CS as a seller, you will be requested to pay purchase price only.