What Is a Drop Lock?
A drop lock is an arrangement whereby the interest rate on a floating-rate note or preferred stock becomes fixed if it falls to a specified level. Above that level the rate floats based on a benchmark market rate, typically with a semiannual reset. In other words, drop lock bonds marry the attributes of both floating-rate securities and fixed-rate securities. The drop lock effectively sets a floor on the rate and a guaranteed minimum return to the lender or investor.
For the borrower, the drop lock bond may offer the advantage of a lower floating rate in return for this guaranteed minimum and possibility of locking in interest while rates are low.
- A drop lock is a bond that has a floating rate with a minimum level, at which the rate locks and the bond converts to a fixed rate.
- 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.
- Drop lock investments also protect the issuer by potentially locking the interest rate in the case of the rate dropping then climbing later.
Understanding Drop Locks
Drop lock bonds are issued to investors with a floating-rate interest which can reset on a semiannual basis, at a specified margin that hovers above a declared base rate linked to a particular benchmark. Most floating-rate instruments pay coupons equal to some widely followed interest rate or a change in a given index over a defined time period, such as the 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 the specified minimum rate for the remaining lifetime of the bond.
Once the benchmark is chosen, issuers establish the additional spread that they are willing to pay in excess of the reference rate—generally expressed in basis points, which are added to the reference rate, in order to determine the overall coupon. For example, take a drop lock bond issued with a spread of 50 basis points above 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 any 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 the same maturity.
The fixed-rate behavior of drop lock bonds may 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 change to a degree that’s determined by the time left remaining until maturity or call date, potentially triggering capital gains.