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A bond floor is the maximum decrease in value that a given bond issue can experience, when allowing for the remainder of repayment on the principal and any other future interest that is due on the bond between the present time and the point of maturity. The term is also used to refer to the minimum or floor value of a portfolio as defined in some type of constant proportion portfolio insurance. In this scenario, the level defined in the insurance protects the investor from experiencing losses beyond a certain point.
As a bond floor relates to convertible bond issues, the establishment of this minimum amount of value helps to increase the attractiveness of this type of bond to investors. By protecting bond buyers from at least a portion of the possible downward move in the stock price of the underlying asset, investors can be assured of earning at least this minimum rate of return over the life of the bond. At the same time, convertible bonds offer the potential to increase in value if the underlying asset do appreciate in value, when and as investors choose to exercise the right to convert those bonds.
The presence of a bond floor in constant proportion insurance provides a similar level of protection for investors. Since this type of insurance is often a good idea when diversifying a financial portfolio, an investor can use this mechanism to hedge against the possibility of certain holdings decreasing in value. While a diversified portfolio normally contains securities that carry different levels of risk, any one of those assets could experience some sort of downturn. By carrying insurance on the portfolio by means of this type of embedded bond feature, the risk of experiencing more than a certain amount of loss at any given time is kept to a minimum. At the same time, the coverage does not inhibit the growth potential of the portfolio, effectively providing the investor with a lot to gain and only a little to lose.
With both applications, the concept of a bond floor is to provide additional security to investors that they will earn at least a certain amount of return from their investments, at least in terms of not losing more than a certain amount. When coupled with investment options that do show promise of gaining rather than losing over time, the presence of this type of floor simply increases the chances of earning a decent level of return from the investment activity. Investors often look closely at this bottom line or bond floor figure and consider this aspect of the investment right along with the potential return.
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