Building a Floating BBB Yield Curve for Early Redemption Pricing
Summary
The document considers how to set compensation when a bond is redeemed before maturity. The proposed goal is to give the bond buyer principal plus a return that reflects BBB credit risk over the holding period, while floating coupons tied to one-year Treasury rates help address interest-rate changes. Coupon terms and the redemption index could be designed separately, though a shared structure might be easier to explain.
As a starting point, the author considers resetting the return annually to one-year Treasuries plus 200 basis points, but questions whether that is adequate for longer holding periods. They seek a way to derive a floating BBB curve from more available Treasury or corporate curves, accounting for credit spreads and the economics of floating-rate exposure. The document proposes, but does not develop, a term-specific redemption schedule based on Treasury rates at each maturity. It gives no market data, calibrated spread model, or valuation evidence, so the proposed spread and curve adjustments remain open questions.
Key ideas
- Early redemption compensation can be framed as principal plus a BBB-level return for the time the investor’s capital was outstanding.
- Floating coupons tied to one-year Treasuries are intended to reduce exposure to rising interest rates.
- A simple candidate resets the return annually to one-year Treasuries plus 200 basis points.
- A modeled BBB curve could start from Treasury or corporate curves and incorporate credit spreads and floating-rate adjustments.
- The document does not provide a calibrated model or evidence that its proposed spread is adequate over longer terms.
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Full text
# Model a floating rate BBB yield curve # Model a floating rate BBB yield curve Background: We want to design a compensated prepayment liability index to define an amount a bond buyer would need to receive in a redemption prior to the nominal maturity of a bond. Ideally we'd like to deliver a floating rate BBB return (with the rate reset each year) through redemption. Said another way, at redemption the bond buyer will receive their entire principal + a return over the bond's rating through the length of time we have the bond buyer's money. OR another way, think of a something like a high quality corporate bond that one can redeem if you deliver a higher (BBB) return (with the floating feature to hedge rate increases). The bond's coupons float at 1 year Treasuries + something subject to CAPS and FLOORS. The compensated prepayment liability index does not need to align with how we calculate coupons, but it might make for a simpler description of the instrument. If I could find a floating rate BBB yield curve (going out to perhaps 10 years) that would work or at least serve as a starting point, but I haven't found a ready example of one. Even a fixed rate BBB yield curve would help, then I could make some kind of adjustment for it floating. If anyone can suggest sources or Bloomberg pages I can call up for either these, that would help a lot. To model a floating rate BBB return we've looked at resetting the rate each year to 1 year Treasuries + 200 bp and this might make a fair compensated prepayment if the company issuing the bond can redeem it in under 5 years. It just doesn't look rich enough to me over longer timeframes, but my colleagues and I are divided on this. Question: I'd like to develop a simple model, from which to derive a floating rate BBB yield curve from something more basic and readily available, like the US Treasury yield curve or a Corporate Bond yield curve. Clearly, it will need factors to address the spread between BBB and treasuries or corporates and something to fairly price floating. It might also need a kind of altered float, perhaps something like the following redemption schedule: - 1 year: 1 year treasuries + n bps - 2 year: 2 year treasuries + n bps - 3 year: ... Any suggestions of how to go about this, think about it, or sources to inform it much appreciated.
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