What is a range accrual note and how does its payoff depend on the reference rate staying within a band?

A range accrual note is a structured product that pays a coupon only for the days when a specified reference rate stays within a predetermined range (the accrual band). If the rate moves outside the range, no interest accrues for those days.

Structure:

Daily accrual = (Annual coupon / 360) x 1{reference rate in range}

Total coupon for period = Annual coupon x (Days in range / Total days in period)

Example — Bridgewater Structured Note:

• Par: $1,000,000
• Maturity: 3 years
• Stated coupon: 7.5% (enhanced rate)
• Range: 3-month SOFR between 3.0% and 5.5%
• Observation: Daily

Quarterly Coupon Calculation:

In Q1 (90 days), 3-month SOFR stays between 3.0-5.5% for 72 days and moves outside for 18 days.

Coupon = 7.5% x (72/360) x $1,000,000 = $15,000

If the rate had stayed in range all 90 days:

Coupon = 7.5% x (90/360) x $1,000,000 = $18,750

The investor lost $3,750 for the 18 out-of-range days.

Investor's Implied View:

By purchasing a range accrual note, the investor is expressing:

1. Low volatility view: Rates will remain stable within the range
2. Range-bound rates: Neither significant tightening nor easing expected
3. Willingness to sell volatility: The enhanced coupon compensates for the embedded short option position

Decomposition:

A range accrual note = Fixed-rate bond + series of daily digital options

The investor is effectively selling digital options on each observation day. If the rate is in range, the option expires worthless and the investor keeps the premium (the enhanced coupon). If out of range, the investor loses that day's coupon.

Risk-Return Profile:

CFA Exam Relevance: Range accrual notes illustrate how structured products embed derivative positions. Understand the implied view and the risk of zero-coupon scenarios.

For more on structured fixed income, explore our CFA course.