valuing cash flows based on floating rate index

[buylowersellhigh]

CofBF,

 

How does one go about valuing a portfolio of loans whose cash flows are based on a floating rate index? So a bunch of commercial loans based on LIBOR plus a fixed spread.

 

What is the methodology to determine the discount rate in this instance? Does the spread on the underlying loans have any reflection on the discount rate used?

 

TIA,

BLSH

 

[odin]

The textbook answer is to value a floater as if it matures at the next coupon payment.  See this link.  http://breakingdownfinance.com/finance-topics/bond-valuation/floating-rate-bond-valuation/

 

Using the risk free+spread on the loan as the discount rate will result in a value of 100.  Prices above or below par will be due to a change in credit quality.  If the credit quality of the borrower has deteriorated since the loan was taken out, and therefore the spread on a replacement loan would be higher, the loan will be priced at some discount to par.  Alternatively, if the credit quality has improved since issuance, the loan should be valued at a premium. 

[buylowersellhigh]

Could you have a scenario where discount rates used to value such a portfolio move from ~4% to 7% without deterioration in credit quality?  So if risk free rates move up or credit spreads move up or combination of both, correct? 

 

The value of the portfolio would go down, but credit quality might be okay.

[odin]

Changes in risk free rates have no impact on floaters...that's the whole point of the floating rate feature.  Yes your discount rate would change along with the risk free rate, but the coupon also changes. 

[TwoCitiesCapital]

Could you have a scenario where discount rates used to value such a portfolio move from ~4% to 7% without deterioration in credit quality?  So if risk free rates move up or credit spreads move up or combination of both, correct? 

 

The value of the portfolio would go down, but credit quality might be okay.

 

Traditionally, credit spreads compress when rates rise because rates typically rise in an environment of healthy economic growth making borrowers better credits.

[buylowersellhigh]

So is the credit quality of the portfolio the main reason a portfolio's value of floaters would go down?

[odin]

Credit quality is a primary factor in determining the price of a floater.  Liquidity can also be very impactful.  I suspect your portfolio of commercial loans would trade with a fairly substantial liquidity premium. 

[buylowersellhigh]

Does anyone have a sense of spreads on RE loans from late 2014 to Sept 2015 or thereabouts?  Obviously, this is a broad brush question. 

 

Did spreads tighten 200-250 bps?  Is there any data out there to corroborate or refute this?

 

TIA,

BLSH

[TwoCitiesCapital]

Does anyone have a sense of spreads on RE loans from late 2014 to Sept 2015 or thereabouts?  Obviously, this is a broad brush question. 

 

Did spreads tighten 200-250 bps?  Is there any data out there to corroborate or refute this?

 

TIA,

BLSH

 

I don't know about RE loans, but MBS spreads were about 6-7 bps wider as compared to LIBOR from 12/31/14 - 9/30/15. Maybe anywhere between 20-30 bps wider compared to Treasuries depending on which part of the curve you're looking at.

 

I wouldn't think that Real Estate loans would be so significantly different from MBS to warrant hundreds of bps difference between the two.