Analysis of Floating Rate Bonds and the Firm Characteristics

Abstract

We examine the security and firm characteristics of a sample of 2,027 non-convertible investment grade floating rate securities (bonds) issued by the US based firms between 1980 and 2018. These bonds pay a coupon based on short term reference rate, such as fed funds rate, plus a fixed quoted margin. Considerable number (81.6%) of these issues are between 1992 and 2007 signifying floating rate as an effective mechanism to mitigate firm’s interest rate risk when the rates are high and expected to fall. A positive and significant abnormal return (CAR = 0.27%), in the event window surrounding issue date, provides strong evidence that the floating rate is viewed as a less restrictive provision as compared to the call option. Majority of the issues (89.3%) are non-callable since the floating rate mitigates interest rate risk for the issuing firm. Lack of put provision in these bonds (in only 7.35% of the sample issues) signifies no significant investor concerns of falling bond prices. Regression analysis reveals that firms with growth options and with higher leverage experience positive CAR due to the financial flexibility these bonds provide. Firms with higher level of information asymmetry benefits less from issuing these securities since most of these bonds (90.13%) are issued at par therefore, the price is not likely to carry information content that mitigates information asymmetry between the firms and the investors.

Floating Rate Notes in High Rate Environment and the Stock Market Response

“…A typical call provision in the bond is associated with the call protection and call premium which can be restrictive and costly to the firm. Tewari et al (2021) find significant and positive stock price reaction to the issuance of FRNs since the floating rate bonds are less restrictive and costly than the call option.…”

“…Another study of treasury FRNs finds that since the treasury FRNs trade at a near constant price, they trade at a premium above the T-bills and notes (Fleckenstein and Longstaff, 2020). Tewari and Ramanlal (2021) find positive stock price reaction on issue date of FRNs. They contend that the floating rate serves the same role as the call option in reducing the interest rate risk for firms but lack the restrictions associated with the call option.…”

“…These are likely adopted to mitigate, to a certain extent, the firm's interest rate risk and the investor's reinvestment risk in case of extreme rate movements. Tewari and Ramanlal (2021) in their analysis of FRNs issued between 1980 and 2018 find positive and significant abnormal returns surrounding the issue date. They find that the most of these issues are investment grade with only a small fraction of these issues with call option.…”

Investment Decision with Floating Rate Loan Choice Based on NPV Approach

“…As can be seen in the last chapter, [12] derived an optimal instantaneous interest rate r * lower than the break-even rate r0 for a management team to undertake the project. However, this implicitly assumes that the cost of capital would be the same as this optimal short-term interest rate over the economic life of the project therein once the investment is made, whereas it is often not the case a firm will always use financing instruments with a fixed rate.…”