Introduction
Nowadays, many individuals are aware of floating-rate home loans, wherein the rate of interest payable on the home loan varies with the changes in interest rates in the economy. This arrangement works better for both the borrower and the lender as they end up paying and receiving the realistic cost of funds. In the bond markets, there are floating-rate bonds, which work similarly. In these cases, the investor is entitled to receive a variable rate of interest at regular intervals, as per the terms of the bond. In this article, you can get more information on what floating rate bonds are, how they work, their features, advantages and types.
Floating Rate Bonds – Meaning
Before getting into how floating rate bonds work, it pays to understand why companies and governments want to issue floating rate bonds. Companies and governments want capital for various purposes including repayment of previous loans. Incremental capital ensures growth for many businesses. Issuing debt is a quick and reliable solution to the capital-raising needs of corporates. Traditionally, they issued bonds that offered a fixed rate of interest over the tenure of the bond. For example, a company may issue a three-year bond that pays an 8% rate of interest at the end of each year. As financial markets evolve and the business cycle shortens, the interest rates also oscillate faster. That calls for debt instruments with variable rates of interest. Hence, floating rate bonds are issued by some companies, wherein the investor gets paid at a variable rate of interest.
How Do Floating Rate Bonds Work?
As stated earlier, a floating-rate bond offers variable interest rates. The interest on a floating-rate bond can be linked to an external variable, such as the repo rate set by the Reserve Bank of India, a 10-year benchmark bond yield, or the yield on a 180-day treasury bill. An example can best explain this.
A five-year corporate bond offering a floating rate of interest issued in January 2022 decides the payoff linked to the repo rate. The interest is payable at the end of the quarter. At the time of issuing the bond, the rate of interest was at 8%. The Reserve Bank of India (RBI) began the rate hike cycle to contain inflation in May 2022. This has led to a sustained increase in the rates payable to the investor. At the end of March 2023, the investor is entitled to be paid at the rate of 10.5%. In this example, if the RBI decides to cut the repo rate, then the rate payable on the floating rate bond will also move down. Given the nature of the debt instrument, floating rate bonds may be attractive in a rising interest rate scenario.
Key Features of Floating Rate Bonds
Here are the essential features of a floating rate bond:
• Variable Interest Payments: The primary feature of floating rate bonds is that their interest or coupon payments change in line with the benchmark rate. This means that in a rising interest rate environment, your income could increase. However, in a falling rate scenario, your income might decrease.
• Coupon Reset Periods: Floating rate bonds typically have reset periods, which could be every month, quarter or semi-annually. During these intervals, the bond’s coupon rate is recalculated based on the prevailing market interest rate.
• Price Stability: Since the coupon adjusts with market rates, floating rate bonds tend to have more price stability compared to fixed-rate bonds, especially in a rising interest rate environment.
Types of Floating Rate Bonds
Floating rate bonds come with interest rates that adjust based on market fluctuations. In the context of India, these bonds can be classified into two main types:
• Callable Floating Rate Bonds: This type allows the issuer to redeem the bond before its maturity, paying back the principal amount to the bondholder in full.
• Non-Callable Floating Rate Bonds: Non-callable floating rate bonds do not provide the issuer with the option for early redemption. The issuer must continue paying interest linked to a benchmark, even if it leads to financial difficulties.
Floating Rate Bonds vs Fixed Rate Bonds
When comparing floating rate bonds and fixed rate bonds, the key difference lies in how interest payments are structured. Floating rate bonds have variable interest payments that adjust periodically based on a benchmark rate. This means that as interest rates rise, your returns from floating rate bonds can increase, offering protection against inflation and rising market rates. However, if rates fall, your income from these bonds may decrease.
In contrast, fixed rate bonds offer a steady, unchanging interest payment throughout the bond's life, regardless of fluctuations in the market. This can provide predictable income, which is beneficial if you value stability in your portfolio. However, fixed rate bonds tend to be more vulnerable to interest rate risk. In a rising rate environment, the value of your fixed-rate bond could decline since newer bonds may offer higher returns.
Advantages of Floating Rate Bonds
The following are the various advantages of floating rate bonds:
• Rise in Interest Rates: These bonds offer higher payoffs in a rising interest rate scenario. Fixed-rate bonds see capital loss when the interest rates move up fast.
• Low-Interest Rate Risk: Floating rate bonds offer an effective hedge against a rise in interest rates. The price of the bond does not fall in a rising interest rate scenario, and the investor gets paid more when the rates rise.
• Less Volatility: Floating-rate bonds can mitigate interest rate risk, resulting in less volatility in the bond portfolio. The investor need not recalibrate her debt portfolio, taking into account the fixed income outlook.
• Diversification: An investor fully invested in fixed-rate bonds may find floating-rate bonds an effective means of diversification within a fixed-income portfolio.
Things to Consider with Floating Rate Bonds
While floating rate bonds provide a multitude of benefits, they also come with certain limitations you ought to keep in mind:
• Low Interest Rates: Though floating rate bonds offer higher rates in a rising interest rate regime, they do offer lower interest rates when the interest rates fall. Hence, investors looking to lock in the yields at the peak of the interest rate cycle typically shun the floating rate bonds, fearing lower interest receipts.
• Credit Risk: If you are investing in corporate floating rate bonds, you should assess the creditworthiness of the issuer. Corporations with lower credit ratings might offer higher spreads over the benchmark rate, but this comes with the risk of default.
• Tax Implications: Interest received on the floating rate bonds is taxable in the hands of the investor. The slab rate of the investor applies to the interest receipts.
• Reinvestment Risk: If the bond is callable, meaning the issuer can redeem it before maturity, you may face reinvestment risk. If interest rates are lower at the time of redemption, you might struggle to find an investment with similar returns.
How to Invest in Floating Rate Bonds
You can buy government-issued floating rate bonds directly through platforms such as RBI’s Retail Direct Scheme or through brokers. Corporate floating rate bonds can be invested through your broker account.
Floating rate bonds offer a distinct advantage in dynamic interest rate environments, making them a valuable addition to your investment portfolio. With their potential for higher returns during rising interest rates, they can provide a flexible income stream while helping you mitigate interest rate risks. As with any investment, it's important to evaluate your financial objectives and risk tolerance. Explore bonds and other fixed-income options with Altifi. Backed by Northern Arc, Altifi offers a seamless platform for accessing high-quality investments. Altifi connects you to a diverse range of investment opportunities, allowing you to optimise your portfolio. Sign up on Altifi and start investing in bonds.
*Disclaimer: The contents of this article should not be construed as tax or financial advice. Readers should seek advice from their tax or financial advisor before making any investment decision.