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Comparing hybrids with trading margins
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Trading margins are a tool for comparing floating rate securities. The future yield of a floating rate note (FRN) depends both on the floating base rate and the margin. It's not possible to calculate exactly the future yield because the Bank Bill Swap Rate (BBSW) will change, which will change the distribution in turn. The trading margin allows us to compare securities.
Floating Rate Securities A floating rate note (FRN) pays a cash distribution of the Bank Bill Swap Rate (BBSW) plus a margin. So for instance Orica’s ORIPB pays an unfranked semi-annual coupon at the 6 Month Bank Bill Swap Rate + 1.35%. The BBSW is within a few basis points of the rate at which major financial institutions will lend Australian dollars to each other - it is the effective interest rate in the liquid short term bank accepted bill market. The BBSW normally sits a little above the Reserve Bank cash rate and changes every day. The margin varies from security to security. The face value is generally $100 per security. An important exception is CBA securities where the face value is $200. | ||
Credit quality is the biggest price driver, but other factors like extension risk, that is the risk the will not redeem for $100 but instead leave the security on issue and continue to pay distributions important. In general the riskier the security, the wider the margin.
Suppose I buy ORIPB at $96.50, and ORI redeem it on 30/11/2011 for $100. I will receive three half yearly distributions at BBSW + 1.35%, about $3.10 at the current BBSW, and also the $3.50 difference between the purchase price and the redemption price. So note's cash flow comes from two sources, the coupon and the return of the face value. But if the margin was higher, say the coupon was BBSW + 3% for a $3.92 semi-annual distribution, then the market price would be higher and the final capital gain a bit smaller.
At some point the margin is large enough that investors would accept zero capital gain to get into the security - they'd be happy with the coupon alone. This is the trading margin. For ORIPB we calculate this at 4.87%. So if ORIPB paid BBSW + 4.87%, then investors would be happy to pay $100 for the security. Another way to say this is that we think ORI could issue more hybrids which mature on the same date as ORIPB at BBSW + 4.87%.
But BBSW changes - how do we deal with this? We look at the interest rate swap market. An institutional investor can swap floating BBSW payments into payments at a fixed rate. We assume an investor does this for both securities in question, and use the derived fixed rate to compare the two securities.
So the trading margin gives an apples-with-apples comparison of the yield on two floating rate securities. In practice we see the trading margin closely corresponds to the market opinion of the quality of the security. Low quality securities generally trade at wider trading margins because they are riskier. But securities of equivalent quality trade at pretty much the same trading margin.
Several factors influence quality and make trading margins large or small. First is the credit quality of the business which issues the security. High credit quality issuers trade at a premium to low quality issuers. Sector makes a difference - industrial businesses trade at a premium to financial companies with the same credit rating. And a transparent, easily understood business will trade at a higher price than a complex murky business.
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