Bond Floor

What Is a Bond Floor?

A bond floor alludes to the base value that a specific bond, normally a convertible bond, ought to trade for. The level of the floor is derived from the discounted present value of a bond's coupons, plus its conversion value.

A bond floor may likewise be utilized in constant extent portfolio insurance (CPPI) estimations. While utilizing CPPI computations, an investor sets a floor on the dollar value of their portfolio and afterward structures asset allocation around that decision.

Understanding the Bond Floor

The bond floor is the lowest value that convertible bonds can fall to, given the present value (PV) of the excess future cash flows and principal repayment. The term can likewise allude to the part of constant extent portfolio insurance (CPPI) that guarantees that the value of a given portfolio doesn't fall below a predefined level.

Convertible bonds give investors the possibility to profit from any appreciation in the price of the responsible organization's stock (in the event that they are changed over). This additional benefit to investors makes a convertible bond more significant than a straight bond. In effect, a convertible bond is a straight bond plus a embedded call option. The market price of a convertible bond is comprised of the straight bond value and the conversion value. (The conversion value is the market value of the underlying equity into which a convertible security might be traded.)

Special Considerations

At the point when stock prices are high, the price of the convertible is determined by the conversion value. In any case, when stock prices are low, the convertible bond will trade like a straight bond — given that the straight bond value is the base level a convertible bond can trade at and the conversion option is almost irrelevant when stock prices are low. The straight bond value is, hence, the floor of a convertible bond.

Investors are protected from a descending move in the stock price in light of the fact that the value of the convertible bond won't fall below the value of the traditional or straight bond part. At the end of the day, the bond floor is the value at which the convertible option becomes worthless in light of the fact that the underlying stock price has fallen substantially below the conversion value.

The difference between the convertible bond price and its bond \ufb02oor is the risk premium. The risk premium can be seen as the value that the market puts on the option to switch a bond over completely to shares of the underlying stock.

Working out the Bond Floor for a Convertible Bond

$\begin &\text = \sum_ ^ \frac{ \text }{ ( 1 + r ) ^ t} + \frac{ \text }{ (1 + r) ^ n }\ &\textbf \ &\text = \text \ &\text = \text \ &r = \text \ &n = \text \ \end$
Or then again:
$\begin &\text = \text${\text } + \text\text \ &\textbf \ &\text = \text \ \end

Illustration of a Bond Floor

For instance, expect a convertible bond with a $1,000 par value has a coupon rate of 3.5% (to be paid every year). The bond develops in 10 years. Consider there is likewise a comparable straight bond, with a similar face value, credit rating, interest payment schedule, and maturity date of the convertible bond, however with a coupon rate of 5%.

To find the bond floor, one must ascertain the current value (PV) of the coupon and principal payments discounted at the straight bond interest rate.
$\begin \text_\text &= 1 - \frac{ 1 }{ (1 + r) ^ n } \ &= 1 - \frac{ 1 }{ 1.05^ {10} } \ &= 0.3861 \ \end$

$\begin \text$\text &= \frac {.035 \times $1,000 }{ 0.05 } \times \text\text \ &= $700 \times 0.3861 \ &= $270.27 \ \end

$\begin \text_\text &= \frac {$1,000 }{ 1.05 ^ {10} } \ &= $613.91 \ \end$

$\begin \text &= \text${\text } + \text\text \ &= $613.91 + $270.27 \ &= $884.18 \ \end
In this way, even on the off chance that the organization's stock price falls, the convertible bond ought to trade for at least $884.18. Like the value of a standard, non-convertible bond, a convertible bond's floor value vacillates with market interest rates and different factors.

Bond Floors and Constant Proportion Portfolio Insurance (CPPI)

Steady Proportion Portfolio Insurance (CPPI) is a mixed portfolio allocation of risky and non-risky assets, which fluctuates relying upon market conditions. An embedded bond feature guarantees that the portfolio doesn't fall below a certain level, in this manner going about as a bond floor. The bond floor is the value below which the value of the CPPI portfolio ought to never fall (to guarantee the payment of all future due interest and principal payments).

Via carrying insurance on the portfolio (through this embedded bond feature), the risk of encountering in excess of a certain amount of loss at some random time is kept to a base. Simultaneously, the floor doesn't repress the growth capability of the portfolio, effectively giving the investor a great deal to acquire — and simply a little to lose.

Highlights

• Bond floor can likewise allude to the part of steady extent portfolio insurance (CPPI) that guarantees that the value of a given portfolio doesn't fall below a predefined level.
• The difference between the convertible bond price and its bond \ufb02oor is the risk premium, which is the value that the market puts on the option to switch a bond over completely to shares of the underlying stock.
• Bond floor alludes to the base value a bond (generally a convertible bond) ought to trade for and is calculated utilizing the discounted value of its coupons plus redemption value.