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Floating Rate Securities
Background and Portfolio Impact

A floating rate security, known as a floater, is any security whose rate is indexed to another security, or index, and moves in accordance with that index in some set formula. It is a derivative in that its value is derived from or influenced by the embedded option which causes it to float - in this case the index. Most floaters are created by agencies of the US Government.

Most commonly, the securities float on recognized indexes or rates such as the last auctioned Treasury Bill auction rate, the London Interbank Borrowing Rate (LIBOR), prime rate, or the Fifth District Cost of Funds Index (COFI). As these indexes move the floaters move with, or inverse to, their index on a set formula. The choice of the index influences the amount of risk in the security since some indexes are naturally more volatile than others and therefore cause the floaters rate to be more volatile.

The securities normally do not float continuously but instead are compared to and change in value at set intervals against their index. That scheduled point in time is called a reset date. The reset date is dependent upon the type of index as well as the schedule. A T-Bill reset might occur once a week when the Bill is auctioned or a prime floater may reset only once a quarter, some floaters reset daily. There is no established schedule. As a result, the floater security has two dates important to the investor: the reset date and the maturity date. At the reset date the security can change value. At its stated (final) maturity date it will mature.

Most floaters are expected to reset to a price of par (100) and restart its float. However, there is no guarantee. Since the embedded option or reset adds risk to the security the owner of the security demands and is given additional yield to compensate them for the risk. The value is influenced by the volatility of the index.

In the measurement of risk in a portfolio the investor looks at the diversification of that portfolio and the overall length of the portfolio as well as the risk embedded in it or represented by different type securities. To do so, the investor looks at diversification by market sector and at stated maturities in the portfolio (knowing that longer securities represent more risk). The length of the portfolio is measured through the mechanism of a weighted average maturity (WAM) calculation. For example, longer securities are by nature more volatile. It requires a larger change in price in longer securities to effect the same amount of rate change as in a shorter security (for example, a 10bp change in price on a 2-year changes yield by .17 but only .03 on the 30 year). In addition, the longer security has more inherent risk because as conditions change over time the investor may potentially have an unrealized loss situation develop and have to hold the security to maturity thereby risking liquidity. It is for this reason that the Public Funds Investment Act (PFIA) requires public entities to report the change in market value. If the value changes significantly the reader of the report knows that there is risk in the portfolio from either the structure of securities or from the maturity length.

For this reason also the PFIA requires all public entities in Texas to establish and include in their investment policies a maximum WAM and to calculate their own portfolio's weighted average maturity (WAM) based upon the stated final maturity of every security. When problems and losses developed in derivative mortgage-backed securities (MBS) in 1994 the Act was changed (in 1995) to require that MBS always be judged and reported as stated final maturities to recognize the inherent risks. This avoided the subjective call made by the investor as to when the security would mature - as expected given certain rate scenarios (estimated life) or at maturity. The reporting change was clearly made to allow readers of the investment reports to judge the risk in the portfolios.

The PFIA also authorizes public entities to invest in local government investment pools and money market mutual funds (MMMF). Both of these are structured basically on the SEC's 2a-7 structure for MMMFs. However, the pools are further constrained because, unlike 2a-7 MMMFs, pools must be AAA-rated, have a 60 day instead of a 90-day WAM limitation, must invest only in PFIA authorized securities, have an advisory board, along with other specific conditions to protect the safety of public funds. One additional difference is that SEC registered money funds (2a-7 funds) are allowed to calculate their weighted average maturity based on the reset date of a floating security if there is a high probability that the reset will be at par. Since the PFIA directs the public funds to use the stated maturity date in their calculations but is silent on the calculation of WAM in pools, the question of which authority to use with floaters has become an issue.

If a portfolio uses the stated (final) maturity for calculating WAM it is recognizing all the potential risk in every security position as well as in the portfolio as a whole. It is recognizing and disclosing that if the security does not reset at par it has a potential risk exposure until maturity. A one year security with a daily reset would be recognized as a one year security in this case and not a one day security.

If the portfolio instead uses the reset date in its calculation of WAM it is basing that calculation on a judgement market call (reset price) and not on fact. The reset date use can shorten the WAM significantly. When rates are increasing and a portfolio, for yield purposes, carries half its value in short reset floaters it can halve its stated WAM leading the report reader to believe the shorter length of the portfolio.

Both views are legitimate in the market's eyes. Accountants and auditors tend to favor use of the stated (final) maturity date to recognize all risks and fully inform the reader of risk. The market tends to favor the reset date methodology to capture available yield within the set policy limitations. The PFIA is silent on the specific calculation methods for pools. The intent of the PFIA appears to clearly favor stated final date use for safety and disclosure because of the clear use of this for all other portfolios. However, since it is silent there is a question of whether the reset allowed by the 2a-7 funds or the stated final maturity used by public funds is appropriate. The decision for pools could either clearly define which method is to be used, or, the decision could be a disclosure matter allowing the pools to use the reset calculation but requiring full disclosure under both calculation methods. Until that decision is made the participant in pools and readers of investment reports will not be fully informed in making their investment decisions.