An arrangement whereby the interest rate on a floating rate note or preferred stock becomes fixed if it falls to a specified level.


If a country had a floating exchange rate and a currency that suddenly dropped, the drop lock would fix the exchange rate once it hit a certain level. In other words, drop-lock bond or “DL” bonds marry the attributes of both floating-securities and fixed-rate securities.

DL bonds are issued to investors with a floating-rate interest that’s reset on a semiannual basis, at a specified margin that hovers above a declared base rate that’s linked to a particular benchmark. The most basic floaters pay coupons equal to some widely followed interest rate or a change in a given index over a defined time period, such as the six months London Interbank Offered Rate (LIBOR), U.S. Treasury Bills (T-bills), or the Consumer Price Index (CPI). Once the benchmark is established, this floating interest rate continues until the base rate falls below a specified trigger rate, on an interest fixing date or on two consecutive interest fixing dates, at which time, the interest rate becomes fixed at a specified rate for the remaining lifetime of the bond.

Further Calculations and Other Factors

Also after the benchmark is chosen, issuers establish additional spread that’s they’re willing to pay in excess of the reference rate--generally expressed in basis points, which is added to the reference rate, in order to determine the overall coupon. For example, a floater issued with a spread of 50 basis points above the three-month T-bill rate of 3.00% on the day the floater is issued, its initial coupon will be 3.50% (3.00% + 0.50% = 3.50%). The spread for any particular floater will be based on a variety of factors including the credit quality of the issuer and the time to maturity. The initial coupon of a floater is typically lower than that of a fixed-rate note of the same maturity.

The fixed-rate behavior of DL bonds appeal to securities investors who enjoy 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. However, there are potential downsides for investors who sell their bond holdings prior to maturity,  because the market value of fixed-rate securities fluctuates with changing interest rates, and in a dropping-rate climate, market values will increase to a degree that’s determined by the time left remaining until to maturity or “call” date, potentially triggering capital gains.