DEFINITION of Reset Margin
The reset margin is the difference between the interest rate of a security and the index on which the security's interest rate is based. The reset margin will be positive, as it is always added to the underlying index.
BREAKING DOWN Reset Margin
The reset margin feature is most common with a floating-rate security. 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 added to a reference rate, such as LIBOR, for floating rate obligations. For example, the interest rate of a floating-rate note (FRN) is quoted as 3-month LIBOR plus 0.5%. 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 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, US 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 may demand a higher interest rate of, say 3-month LIBOR plus 0.65%. 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 extendible 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.