Drop Lock

What Is a Drop Lock?

A drop lock is an arrangement by which the interest rate on a floating-rate note or preferred stock becomes fixed in the event that it tumbles to a predefined level. Over that level the rate floats based on a benchmark market rate, typically with a semiannual reset. In other words, drop lock bonds wed the attributes of both floating-rate securities and fixed-rate securities. The drop lock effectively sets a floor on the rate and a guaranteed least return to the lender or investor.

For the borrower, the drop lock bond might offer the advantage of a lower floating rate in return for this guaranteed least and possibility of locking in interest while rates are low.

Understanding Drop Locks

Drop lock bonds are issued to investors with a floating-rate interest which can reset on a semiannual basis, at a predefined margin that drifts over a declared base rate linked to a particular benchmark. Most floating-rate instruments pay coupons equivalent to some widely followed interest rate or a change in a given index throughout a defined time period, like the London Interbank Offered Rate (LIBOR), U.S. Treasury Bills (T-Bills), or the Consumer Price Index (CPI).

When the benchmark is established, this floating interest rate continues until the base rate falls below a predetermined trigger rate, on an interest fixing date or on two consecutive interest fixing dates, when the interest rate becomes fixed at the predefined least rate for the leftover lifetime of the bond.

When the benchmark is picked, issuers establish additional spread that they will pay in excess of the reference rate — for the most part communicated in basis points, which is added to the reference rate, to determine the overall coupon. For instance, a drop lock bond issued with a spread of 50 basis points over the three-month T-Bill rate of 3.00% on the day the bond is issued, its initial coupon will be 3.50% (3.00% + 0.50% = 3.50%). The spread for a particular floating rate will be based on a variety of factors including the credit quality of the issuer and the time to maturity. The initial coupon is typically lower than that of a fixed-rate note of a similar maturity.

The fixed-rate behavior of drop lock bonds might appeal to securities investors who partake in the comfort of locking fixed interest rates with fixed maturity timetables. Bonds held to maturity offer investors preservation of their principal and guaranteed cash flow. In any case, there are potential disadvantages for investors who sell their bond holdings prior to maturity, in light of the fact that the market value of fixed-rate securities fluctuates with changing interest rates, and in a dropping-rate climate, market values will change to a degree that's determined when left excess until maturity or call date, potentially triggering capital gains.

Highlights

• A drop lock is a bond that has a floating rate with a base level, at which the rate locks and the bond converts to a fixed rate.
• Drop lock investments likewise protect the issuer by potentially locking the interest rate on account of the rate dropping then climbing later.
• Drop lock investments appeal to investors who want the security of a fixed rate and maturity time table with the chance at a higher return.