PG 357-358 in CFAI vol. 5, reading 28 This whole concept I’m struggling with right now - I understand why if you OWN a floating rate bond, w/ quarterly payments, your duration is low (0.125 in example), but how are we using this to insinuate that ISSUING that bond, your sensitivity is also low: negative 0.125. Like sure, when you have ISSUED the floating rate bond, the market value of bond resets every quarter, so in that sense the price will never stray too far from par. BUT, if interest rates keep going up, and get reset higher and higher, I don’t see how this is not clearly riskier than a fixed rate bond, where you know the payment every quarter etc. Basically text uses the durations to imply paying the floating, ie. issuer, is less risky than engaging in swap and receiving floating, paying fixed. I’m having a hard time wrapping my head around it and how they can use the negative 0.125 duration on issuing a FR bond as any sort of rationale behind this logic. If I’m not explaining my confusion well, apologies. Also I’m going to read over section again to make sure I’m not missing something key…
Are you talking about price risk or cash flow risk?
Floating-rate bonds have low price risk, high cash flow risk.
Fixed-rate bonds have low cash flow risk, high price risk.
I guess I’m trying to wrap my head around the practicial-real-world application as to why a company PAYING interest, ie. making cash flows periodically, should value the sensitivity of bond price. They do not own the bond. To me, if I’m a corporation, and I am borrowing money and having to pay quarterly interest on it, why do I care whether a floating rate bond’s price is much less risky than a fixed-rate note - if the interest rate keeps climbing all year, sure the bond price resets periodically and it’s value remains close to par, but as the issuer, that doesn’t seem to matter a lick to me, I still keep paying higher and higher interest.
I guess I’m not seeing how the text suggests if a corporation’s mission is to boost shareholder value, how the less risky (floating rate paying) should be valued over fixed rate paying.
What if you want to retire the debt early?
Would that not involve issuing another bond to get the cash to do so? Interest rates are still higher, so they are still screwed for not locking in fixed rate, no? From a value standpoint, of a company, would shareholders value a firm with a liability always close to par (floating rate) even if it means the cash flows/interest payments may continually go up? I may just be making a mountain of a molehill. I realize these answers may not actually help me score better on this exam, I’m just trying to figure out the logic of what CFAI says about issuing corporate floating loans being 6 times less risky than issuing fixed.
Not if the company wanted to reduce their leverage.
also think about the situation (different one from S2000’s) if the company were going to declare bankruptcy? You would have to liquidate your assets to pay off the debt you have incurred - and do this much to the chagrin of the equity holders who gave you money expecting you would give them some returns. (Debt has priority / seniority).
I’m not following. The company took out a loan/issued a bond presumably to use the cash on some sort of operation, ie. to put the cash in use. If interest rates go up, thereby increasing the interest payments on their floating-rate loan, how does the low duration help them here at all? To retire this debt without incurring the losses on the worse interest rate going forward, they must somehow find the cash to do so, or issue another higher rate bond. I just don’t know how the low duration on a floating rate bond helps the issuer or really has any significance. I must be missing something, though.
I understand this but don’t see how it relates to my confusion. Text is saying issuing floating rate bonds over fixed is maximizing shareholder value b/c the floating rate note’s market value is less sensitive to interest rate changes. This is true but if you’re issuer and paying those interest rate payments I don’t see how that is of any significance in lowering your firms risk and maximizing shareholder value. I say that because while yes the bond price resets periodically to bond holder, the issuer gets no such help and must pay the higher rate as it climbs