What Is a Range Accrual?
A range accrual is a structured product based on an underlying index whose returns are maximized if that index stays within the investor's defined range. Commonly referred to as range accrual note, it is a type of financial derivative that offers investors the potential to earn above-average returns by linking its coupon rate to the performance of the reference index.
Variations on range accrual notes include accretion bonds, index range notes, corridor bonds, corridor notes, range floaters, and fairway bonds.
- A range accrual is a structured product based on an underlying index whose returns are maximized if that index stays inside a specific price range over the life of the note.
- A range accrual note offers investors the potential to earn above-average returns by linking its coupon rate to the performance of the reference index.
- If the index value stays within a specified range, the investor is credited the coupon rate, else the investor earns nothing.
Understanding Range Accrual
The investor holding the range accrual security desires the reference index to stay within a specified range from the range accrual's issuance to its maturity. This strategy is a bet on stability or low volatility in the index market, as well as an investment in the note. Since the cash flow is not guaranteed, the issuer often has to offer a higher stated coupon rate to entice investors. For investors speculating that the underlying index will stay range-bound, it is a way to earn an above-average yield.
The reference index could be an interest rate, such as LIBOR. It might also be a currency exchange rate, commodity, or stock index. If the index value falls within a specified range, the coupon accrues or is credited interest. If the index value falls outside the specified range, the coupon rate does not accrue, meaning that the investor earns nothing.
Typically, the bet is that the reference index will stay confined to the investor's anticipated ranges and not be swayed by the heightened volatility of other market-moving factors. These factors could be a steepening yield curve, a futures market in backwardation or contango, or other geopolitical events. Basically, the investor is betting against the market in the hopes of earning above-market returns.
Investors in accrual range notes profit the most during a sideways market, which is when the price of a security is rangebound without forming any distinct up- or downtrend.
Since it has a fixed coupon rate, a range accrual qualifies as a fixed-income security, but in name only. Another name for the coupon is a conditional coupon since its yield payment depends on another event or condition. The payment calculation time frame is usually daily. Since actual interest payments can be zero for any given return calculation period, real income is not necessarily fixed.
No official market exists for range accrual notes trading or valuation. Valuations become even trickier with range accruals which include call features and dual-range accruals. A dual-range accrual is one that uses two indexes based on, for example, an exchange rate and interest rate.
Calculating Range Accrual
Range accrual notes start with the same calculations used on any fixed-income security, matched with the payment period. Payment periods may be monthly, semi-annually, or annually. The inclusion of a yes or no type of modifier is the main difference between the securities.
For example, say an investor holds a 3% coupon, one-year note with a monthly payout. The index base for the security is the price of crude oil trading in New York, with a range between $60.00-$61.00 per barrel. Annualized monthly payments range from 0.00% to a maximum of 3.00%.
- For January, payable on February 1st, assume that crude oil traded in that price range for 15 of the 31 days of the month.
The interest payment made on February 1st would be 1.45% times the principal value divided by 12.
- For February, payable on March 1st, with the index within range for 20 days, it would be as follows:
- The interest payment made on March 1st would be 2.14% times the principal value divided by 12. If the index remains in range the entire month:
The interest payment made on the first day of the next month would be 3.0% times the principal value divided by 12; repeat the calculation for all other months.
Range Accrual Notes and Interest Rate Options
Accrual range notes may carry either a short-term floating interest or have an embedded interest rate option. A floating (variable) interest rate moves up and down with the rest of the market or along with an index. This is why some range accrual notes like fairway bonds are also known as index floaters.
An interest rate option is a financial derivative that allows the holder to benefit from changes in interest rates. It is similar to an equity option and can be either a put or a call. Typically, the movement follows an underlying benchmark rate, such as the yield on the 10-year Treasury note.