What Is the Reset Margin?
The reset margin is the difference between the actual interest rate of a loan or debt security and the index upon which its interest rate is based. The reset margin will always be positive, as it is added to the underlying index or reference rate.
- The reset margin is the amount of interest added to a floating interest rate product when the variable rate resets.
- The reset margin is typically expressed as basis points or percentage points above some index or reference rate such as LIBOR.
- Reset margins are commonly seen in securities such as floating rate notes or swaps, as well as in consumer loans such as ARMs.
Understanding the Reset Margin
The reset margin feature is most commonly seen with floating-rate securities or loans. It is the rate above a reference rate or index that is used to determine the interest rate for an adjustable-rate security. The reset margin is then added to a reference rate, such as LIBOR, for floating rate obligations.
The reset margin is typically expressed in basis points (bps) or percentage points, which are added to the prevailing reference rate when a floating or variable interest rate product resets (typically on a quarterly, semi-annual, or annual basis). So, if an ARM mortgage is issued with a reset margin of 150 bps above LIBOR, resetting every six months, then the ARM's effective interest rate would be LIBOR + 1.5% on each reset date.
Examples of the Reset Margin
The reset margin is also used extensively in variable rate debt securities. For example, say the interest rate of a floating-rate note (FRN) issued by ABC Corp. is quoted as 3-month LIBOR plus 50 bps. The 0.5% is the reset margin, meaning that if LIBOR is 2.36% then the interest rate on the note will be set at 2.86%. Banks can borrow money at LIBOR without any markup and, in order to realize profits on loans, will add the reset margin when lending funds.
Other possible indices or reference rates include the prime rate, Euro Interbank Offer Rate (EURIBOR), federal funds rate, U.S. Treasury rates, etc. When interest rates rise, the reset margin is increased to reflect the higher rate. For example, if the perception of the creditworthiness of the floating-rate note issuer from the example above turns negative, investors in ABC Corp. may demand a higher interest rate of, say 3-month LIBOR plus 65 bps. In this case, the coupon rate will be adjusted to 3.01%, following the higher reset margin. In effect, the coupon rate resets based on a quoted margin over the LIBOR.
Some adjustable-rate notes, known as extendable reset notes, allow the reset margin to be determined at the discretion of the issuer. For these securities, the issuer can reset the coupon rate so that the security will trade at par or a price above par. For instance, let’s say the coupon rate on a floater is the 1-year Treasury rate plus 1.5%, and the Treasury rate is given as 2.24%. At the coupon reset date (floating rates reset with each coupon payment), the issuing entity determines that the price of the security will trade below par at this rate. It, therefore, adjusts the rate by increasing the reset margin to a level in which the floater will trade at par in the markets. If the credit quality of the security has declined since the last reset date, the reset margin will have to be increased considerably in order for the debt security to trade at par.
For reverse floating-rate debt, the coupon rate is calculated by subtracting the reference interest rate from the reset margin on every coupon date. For example, the coupon on a reverse floater may be calculated as 10% minus 3-month LIBOR. A higher LIBOR would mean more will be deducted from the reset margin and, thus, less will be paid to the debtholder in coupons. Similarly, as interest rates fall, the coupon rate increases because less is subtracted from the reset margin.
According to an announcement by the Federal Reserve in November 2020, banks should stop writing contracts using LIBOR by the end of 2021. The Intercontinental Exchange, the authority responsible for LIBOR, will stop publishing one week and two month LIBOR after December 31, 2021. All contracts using LIBOR must be wrapped up by June 30, 2023.