For Fannie Mae’s Investors and Dealers A Primer on Floating-Rate Notes March/April 2011 Year-to-date through April 2011, floating-rate notes have been issued with increasing frequency in the primary bond market. As evidenced in the corporate sector, nearly $63 billion, or 18 percent, of the marketed invest- ment grade U.S. dollar bonds this year have floating rates1, as compared Some investors to approximately $75 billion in 2010 and $47 billion in 2009. Demand for floating-rate product typically increases when investors expect interest may invest in rates to rise as periodic rate resets allow investors to hedge interest Fannie Mae rate risk. Fannie Mae issues both callable and noncallable floating-rate notes2. floating-rate To provide potential investors with a better understanding of floating- rate notes, this edition of FundingNotes explains the general features of notes in floating-rate notes and discusses historic trends in Fannie Mae’s issuance expectation of of floating-rate notes over the past few years as well as identifies the in- vestor segments that may be interested in investing in floating-rate notes. increasing rates General Features of Floating-Rate Notes in the future. A floating-rate note, often known as a floater, is a debt security that offers interest payments which reset on predetermined dates based on a refer- ©2011, Fannie Mae. No part of this document may be dupli- ence rate. The coupon is calculated in the following manner: cated, reproduced, distributed or displayed in public in any manner or by any means without the written permission of Fannie Mae. This document is for the private information of coupon rate = reference rate + spread dealers in Fannie Mae securities (“Dealers”) and qualified sophisticated institutional investors. Fannie Mae does not The general features of floating-rate notes are listed below: intend to solicit and is not soliciting any action with respect to any Fannie Mae security based upon this document. This document does not constitute, and under no circumstances Spread. The spread is the margin that an issuer adjusts to the reference should it be used as, or considered to be, an offer to sell or rate and is generally expressed in basis points. The spread is set when a solicitation of an offer to buy the securities or other instru- ments mentioned herein or derived from such securities or floaters are priced and does not change. For example, Fannie Mae issued instruments. Fannie Mae expects Dealers to make every effort to assist investors to consider and understand the a five-year floating-rate note on April 6, 2011 with CUSIP 3136FRGA5. risks of the securities or instruments mentioned herein. The securities or other instruments mentioned in this document This floater has a quarterly interest payment and accrues interest at a rate may not be eligible for sale in certain jurisdictions or to certain of three-month LIBOR minus five basis points. Changes in the reference persons and may not be suitable for all types of investors. Opinions and estimates expressed herein constitute our rate will affect the rate at which interest accrues on the security, but does present judgment and are subject to change without notice. Such opinions or estimates should not be construed as not affect the spread. either projections or predictions of value, performance or 3 results; nor as legal, tax, financial, or accounting advice. Reference rate . The reference rate is the interest rate or index used (See back cover.) in the coupon formula to determine the amount of interest that accrues on the security. The most common indices used for floaters include the London Interbank Offered Rate (LIBOR), Prime rate, Fed Funds Effective rate, and U.S. Treasury Bill rate (T-Bill). Other short-term indices such as Constant Maturity Treasury (CMT), Cost of Funds Index (COFI), and Federal Reserve Commercial Paper Composite (CP) can also be used as the reference rate. Please see Figure 1. Depending on the maturity and index type, the spread to the reference rate can be either positive or negative. 1 As of April 15, 2011, SIFMA’s U.S. corporate issuance report is broken out by investment grade/high yield, as well as callable and noncallable. http://www.sifma.org/research/statistics.aspx 2 In this edition of FundingNotes, we focus on noncallable floating-rate notes. 3 Appendix D of Fannie Mae’s Universal Debt Facility Offering Circular provides a list of reference rates to which Fannie Mae’s floating-rate notes may be indexed. http://www.fanniemae.com/markets/debt/pdf/udf_041811.pdf Online at www.fanniemae.com → Debt Securities → FundingNotes 1 Fannie Mae floaters often accrue interest at a rate investors for credit and interest rate risk during the tied to a reference rate. For example, the $250 million term of the security. While floating-rate debt securi- three-year quarterly Prime floater issued on March ties minimize interest rate risk, the higher spreads for 7, 2011 with CUSIP 3135G0BB8 pays a quarterly longer maturity on floaters presumably reflects the risk coupon based on the reported Prime rate on certain of credit changes. designated dates, minus 2.82 percent. The quarterly Cap or Floor. Floaters may be issued with either a payments of accrued interest for this security are “cap,” a “floor” or both. A cap is the maximum inter- based on a fixed spread to the reported daily Prime est rate that the issuer will pay regardless of how high rate. the reference rate may go, and therefore protects the Reset periods. The interest rate on a floater can issuer from escalating interest costs. Conversely, a reset as often as daily or as infrequently as once per floor sets the minimum rate that will be paid even if year. It is quite common for the interest rate to reset the coupon determined by the reference rate were each time an interest payment is made on the secu- lower, and protects the investor from a declining refer- rity, and then remain constant until the next coupon ence rate. Fannie Mae floating rate notes will not ac- payment date. If the interest resets within a payment crue interest at a negative rate, and have an effective period, accrued interest will be calculated by multiply- floor of zero. Depending on the security, Fannie Mae ing the principal amount of the floater by an accrued floaters may have a cap, which would be stated in the interest factor. This accrued interest factor will be security’s pricing supplement. calculated by totaling the interest factors calculated Index exclusion. Major indices such as the for all days in the payment period. The interest factor Barclays Capital U.S. Aggregate Index and Citigroup for each day will be computed by dividing the interest U.S. Broad Investment-Grade Bond Index exclude rate for that day by the number of days in the year. floating-rate notes. Floaters with longer reset periods may be more vul- nerable to interest rate and slight price volatility. The Fannie Mae’s Issuance of longer the reset period, the more a floater will behave Floating-Rate Notes similar to a short-dated fixed-rate security and the Year-to-date through April 15, 2011, Fannie Mae is- greater its price will potentially fluctuate. Conversely, sued approximately $3.8 billion in floating-rate notes, the shorter the reset period, the smaller the potential as compared to $63.1 billion in 2010 and $23.7 billion price fluctuation will be. in 2009. Fannie Mae has issued floating-rate notes Payment periods. Interest payments for a floater tied to a number of different reference rates (Figure 1). may be made monthly, quarterly, semiannually or an- Figure 2 shows Fannie Mae’s issuance of floaters nually. However, the interest payments are calculated based on an accrual basis when the underlying index Common Reference Rates of Fannie Mae’s Floating-Rate Notes* resets more frequently such as daily and quarterly. 3-month Treasury Prime Rate Fed Funds, Daily 1-month LIBOR 3-month LIBOR Bills Interest on floaters is usually not compounded, but Page D-9 D-8 D-4 D-1 D-1 Number in Offering the more frequent the coupon payments, the more Circular Underlying Auction discount rate Prime rate Fed Funds Effective 1-month LIBOR 3-month LIBOR the investor is likely to earn from reinvesting these Reference of the 3-month (quoted as a yield - rate (quoted as a quoted as yield quoted as yield Rate Treasury Bill, no conversion yield - no conversion proceeds. converted to a bond necessary) necessary) equivalent yield Day Count Act/Act Act/360 Act/360 Act/360 Act/360 As mentioned earlier, the Fannie Mae-issued floating- Reference Weekly, following Daily with 1 day Daily with 1 day Monthly - reset Quarterly - reset Rate Reset Treasury Bill auction lookback - lookback - determination determination rate note indexed to the Prime rate has a quarterly Frequency Fri/Sat/Sun use Fri/Sat/Sun use Fri's London calendar 2 London calendar 2 Fri's effective effective days prior/pays on days prior/pays on interest payment period but the Prime rate resets on NYB day calendar NYB day calendar Rate Cutoff 6 days lookback 6 days lookback 6 days lookback 6 days lookback 6 days lookback a daily basis. Therefore, the interest payment will be - if interest rate rate will reset within an interest calculated using an accrual method with the day count period Payment Quarterly Quarterly Quarterly Monthly Quarterly convention of Actual/360. Frequency Average Daily accrual Daily accrual Daily accrual Daily accrual Daily accrual Maturity. Floaters can be issued with any maturity, Method typically ranging between two to five years.