Important Considerations for Floating Rate Bonds

C

Let's analyze each answer choice and determine which one is true regarding the characteristics of the given floating rate bonds.

A. The maximum coupon rate on these bonds would occur when the six-month Treasury bill was at 8.50%. This statement is not true. The coupon rate on these floating rate bonds is based on the six-month Treasury rate plus 200 basis points with a cap of 8.50%. The cap implies that even if the six-month Treasury rate exceeds 8.50%, the coupon rate on the bond will not increase beyond that level. Therefore, the maximum coupon rate on these bonds would not occur when the six-month Treasury bill is at 8.50%. The coupon rate will be capped at 8.50% regardless of how high the Treasury rate goes.

B. These floating rate bonds have more interest rate risk than comparable floating rate bonds that reset annually. This statement is also not true. Generally, floating rate bonds have less interest rate risk compared to fixed-rate bonds because their coupon rates adjust periodically based on changes in reference interest rates. In this case, the floating rate bond in question resets semiannually, meaning the coupon rate will be adjusted every six months based on the current six-month Treasury rate plus 200 basis points. This frequent resetting helps to mitigate interest rate risk as the bond's coupon adjusts in response to changes in market interest rates more frequently than floating rate bonds that reset annually.

C. If the six-month Treasury rate has been greater than 7.00% for the past 12 months, these bonds will be priced similar to comparable fixed-rate securities. This statement is true. If the six-month Treasury rate has been consistently greater than 7.00% for the past 12 months, it implies that interest rates have generally been high during that period. In such a scenario, the coupon rate on the floating rate bond, which is based on the six-month Treasury rate plus 200 basis points, would also be relatively high. As a result, the floating rate bond's cash flows would be similar to those of comparable fixed-rate securities with higher coupon rates, making the pricing of the two types of securities comparable.

To summarize, the true statement regarding these floating rate bonds is: C. If the six-month Treasury rate has been greater than 7.00% for the past 12 months, these bonds will be priced similar to comparable fixed-rate securities.