FLOATING RATE BOND CLASSES
Thus far we have seen how redirecting the principal payments among different bond classes can be used to create bond classes appealing to different types of investors in the bond market and thereby improve the execution of a transaction. The same can be done by redirecting interest payments so as to create bond classes with different exposures to changes in interest rates and prepayment risk. The first bond class type we will discuss is floating rate bond classes.
The structures discussed thus far offer a fixed coupon rate for all bond classes. If only fixed rate coupon bond classes can be created, the market for CMOs would be limited. Because many participants in the financial markets are funded on a floating rate basis, they prefer floating rate assets so as to avoid an asset-liability mismatch.
Can a floating rate tranche be created from fixed rate collateral? As explained when we discuss nonagency CMOs and ABS, it is possible to do so by using interest rate derivatives. Without the use of such derivatives, it would extremely difficult to do so. The reason is that if a bond class is created with a floating rate and the reference rate for that floating rate bond class exceeds the interest rate on the collateral, there would be an interest shortfall for the months where this occurs. One way to handle this problem is to create a floating rate bond class that has an interest rate cap. An interest rate cap is common in the floating rate market. While ...