Variable Coupon Renewable Notes (VCRs): Explained

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 optionsPut OptionA put option is an option contract that gives the buyer the right, but not the obligation, to sell the underlying security at a specified price (also known as strike price) before or at a predetermined expiration date. It is one of the two main types of options, the other type being a call option..

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)LIBORLIBOR, which is an acronym of London Interbank Offer Rate, refers to the interest rate that UK banks charge other financial institutions for 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)Treasury Bills (T-Bills)Treasury Bills (or T-Bills for short) are a short-term financial instrument issued by the US Treasury with maturity periods from a few days up to 52 weeks. 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 maturityTerm to MaturityTerm to maturity is the remaining life of a bond or other type of debt instrument. The duration ranges between the time when the bond is issued until its, 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.

Additional Resources

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• Discount BondDiscount BondA discount bond is a bond that is issued at a lower price than its par value or a bond that is trading in the secondary market at a price that is below the par value. It is similar to a zero-coupon bond, only that the latter does not pay interest. A bond is considered to trade at a discount
• Floating Rate NoteFloating Rate NoteA floating rate note (FRN) is a debt instrument whose coupon rate is tied to a benchmark rate such as LIBOR or the US Treasury Bill rate. Thus, the coupon rate on a floating rate note is variable. It is typically composed of a variable benchmark rate + a fixed spread.
• Interest Rate RiskInterest Rate RiskInterest rate risk is the probability of a decline in the value of an asset resulting from unexpected fluctuations in interest rates. Interest rate risk is mostly associated with fixed-income assets (e.g., bonds) rather than with equity investments.
• Options: Calls and PutsOptions: Calls and PutsAn option is a derivative contract that gives the holder the right, but not the obligation, to buy or sell an asset by a certain date at a specified price.