Fixed-rate bond investors worry when interest rates rise, because this causes bond prices to drop. However, yield investors have the opposite concern. A yield investment is one that pays a variable rate of interest based on prevailing rates. Examples include savings accounts, money market funds and floating-rate bonds. A collar can protect a yield investor from dropping interest rates.
Bonds vs. Yields
A fixed-rate bond produces a yield based on the annual interest it pays out divided by the purchase price. Even though higher interest rates will cause the bond’s price to fall, the yield is unhurt. In fact, because you can reinvest interest at a higher rate, the overall yield actually increases. Falling interest rates boost bond prices and please bondholders. However, a yield investor gets hurt when interest rates fall, because this cuts the return on floating-rate investments.
Interest Rate Collar
An interest collar consists of a cap and a floor. Both are options on a reference rate, such as the London Interbank Offer Rate, or LIBOR. The cap sets a strike rate higher than the current index and the floor has a strike rate that’s lower. To protect against falling rates, you can sell a cap and buy a floor. The floor pays you money when interest rates fall below the floor strike rate. You must pay a premium to buy a floor. You can earn that premium by selling a cap, which requires you to pay money when interest rates rise above the cap strike rate. A short interest rate collar position, consisting of a long floor and short cap, costs little or no money to put on.
Suppose you have $1 million in various savings accounts and money market investments. You currently earn a 4 percent annual yield, or $40,000, in yearly interest income. If interest rates fall to 3.75 percent, you lose $2,500 a year in income. You therefore short a one-year collar: You sell a 4 percent cap on a notional amount of $1 million tied to the three-month LIBOR rate, also currently 4 percent. You use the sale proceeds to buy a 4 percent floor. You will have to pay money to the extent that LIBOR rises above 4 percent but you receive payment if rates below 4 percent. For simplicity, this example assumes that the collar settles up after one year, but interest-rate collars often reset every three months.
In this example, the amount you pay out if interest rates rise is the excess of LIBOR above 4 percent times $1 million. For example, if interest rates rise to 4.15 percent, you’ll pay out 0.15 percent of $1 million, or $1,500. However, your yield-sensitive investments will approximately repay you this amount in the upcoming year because their yields will increase. Conversely, you’ll receive $1,500 if LIBOR falls to 3.85 percent, based on (4 percent minus 3.85 percent) times $1 million. In either case, you’ve hedged your yield on $1 million of interest-rate-sensitive investments.
You can set your collar strikes away from the current rate if you are willing to absorb some risk of an interest rate decline. In return, you are less likely to have to pay out on your short cap. For example, you could sell a 4.25 percent cap and buy a 3.75 percent floor.Click here for reuse options!
Copyright 2019 Eric Bank, Freelance Writer