Drop Lock Bond
The drop lock bond is a variable rate security that pays the holder coupons indexed to an underlying parameter. The bond incorporates a clause whereby, if the indexation parameter falls below a certain limit (called the "trigger rate"), the subsequent coupons will be calculated on the basis of a fixed rate, established in the issue regulation, which may be equal to or greater than the trigger rate.
In essence, this bond incorporates a guarantee that protects the holder from an excessive reduction in interest rates.
Drop lock bonds are issued with a floating interest rate. Such a rate may be indexed to the London Interbank Offered Rate (LIBOR), US Treasury Bills (T-Bills) or the Consumer Price Index (CPI), for example.
Once the benchmark is established, this floating interest rate continues until the base rate falls below a specified trigger rate (the Trigger Rate), either on an interest fix date or on two consecutive dates interest fixation, at which time the interest rate becomes fixed at the specified minimum rate for the remaining term of the bond.
Once the benchmark has been chosen, issuers establish an additional spread that they are willing to pay in excess of the reference rate, generally expressed in basis points, which is added to the reference rate, in order to determine the overall coupon.
The main advantage of drop lock bonds for an investor is the possibility of coping with an excessive drop in interest rates: in fact, he will have the guarantee that, below a certain fixed benchmark, he will receive fixed interest rates .
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