What is a Variable Coupon Renewable Note (VCR)?
A variable coupon renewable note (VCR) is a type of fixed-income security that is renewable. Its distinguishing characteristic is that the return, which is known as the variable coupon rate, is subject to periodic revisions. Other features of VCRs include embedded put options.
What is Coupon Rate?
A renewable note is a debt security that matures at a weekly rate. The annual interest paid on such a bond is known as the coupon payment. Coupons are expressed in the form of a percentage of the face value and are paid for the duration of the bond’s validity, which is from the issue date until the date of maturity.
The sum of all coupons paid to the investor over a year, when divided by the face value of the bond, gives the coupon rate. The coupon rate is the effective rate of return accruing to the investor.
How is the Variable Coupon Rate Calculated?
In the case of a renewable note with a weekly maturity, the principal amount of the security gets automatically reinvested on each date of maturity at revised interest rates. The new interest rate is effectively reset at a fixed spread over a reference rate.
The fixed spread refers to the difference between the ask and bid prices of a security. The spread remains the same even when market prices change, and thus do not fluctuate because of market conditions. The reference rate here is a benchmark that is used to set other interest rates. Common examples include the London Interbank Offered Rate (LIBOR) and central bank repo rates.
How are Coupons Renewed?
In the case of variable coupon renewable notes, the reference rate is the Treasury bill rate. Treasury Bills (T-Bills) are short-term government debt obligations that are backed by the credit and full faith of the treasury of any sovereign government. Since T-bills can be of different maturities, the rate of return on a 91-day Treasury bill is used as a reference rate.
Thus, the coupon gets renewed at 91-day intervals, or on a quarterly basis. It means that after every 91-day period, the maturity of the coupon gets extended for another 91 days. It happens continuously, and thus, the principal amount of the security gets reinvested. The process is automatic, which means that it will continue until the investor explicitly requests to not reinvest the security any longer.
A variable coupon renewable note is different from a variable rate renewable note. Even though both securities share the characteristic of the security being automatically reinvested at periodic intervals, the rates in variable-rate renewable notes vary monthly rather than weekly. It is because the reference rate is that of a commercial paper rather than a government bond.
What are Embedded Put Options?
The coupons on variable coupon renewable notes include embedded out options. A put option is a stock market instrument that enables its holder to enter into an agreement to sell a security at a predetermined date and at a fixed price.
Thus, the embedded put option allows the holder of the note to exercise her right to sell the note back to the issuer at par on the coupon’s date of maturity, which happens on a quarterly basis.
The issuer of the note is contractually obligated to buy back the note from its holder, but not necessarily at the fixed spread to the reference rate. The issuer can buy back the note at a lower spread.
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