What is Super Floater?
- A super floater is a collateralized mortgage obligation (CMO) tranche whose coupon rate is the leveraged reference interest rate, usually LIBOR, minus the fixed rate (spread).
- Super floaters magnify changes in the reference interest rate, which is why they are often used to hedge interest rate risk in portfolios.
- Super floaters can offer very high yields when interest rates rally or its coupon income can rapidly erode in response to falling interest rates—which is known as prepayment risk.
Understanding Super Floater
Super floaters are like floaters, except floaters are only linked to the underlying interest rate, rather than being a multiple of it. Since the super floaters coupon rate floats according to a formula based on a multiple of an underlying index, it moves up or down by more than one basis point for each basis point increase or decrease in the index. To prevent the coupon rate from getting negative, super floaters often have a floor rate on the coupon.
Super floaters become interest rate sensitive securities, because they magnify any change in the reference interest rate or index. However, this is also why they are often used to hedge interest rate risk in portfolios. Super floaters offer low base case yields, but can offer very high yields when interest rates rally. Conversely, coupon income can be rapidly eroded when mortgage prepayments speed up in response to falling interest rates—which is known as prepayment risk.
For example, take a super floater with the following coupon formula:
- 2 x (one-year US$ LIBOR) - 4%.
- If one-year LIBOR is 3%, the coupon rate would be 2 * 3% - 4% = 2%.
- If LIBOR rises to 4%, the coupon rate would be 2 * 4% - 4% = 4%, even though the reference rate rose by only 1%.
All types of floating-rate tranches may be structured as planned amortization class (PAC), targeted amortization class (TAC)—which offer fixed principal payment schedules—companion tranches or sequential pay CMOs.