Floating Rate Bonds

Floating Rate Bonds: Meaning, Types and Advantages

Floating-rate bonds don’t have a set interest rate. Instead, their rates adjust regularly, following a specific base rate. This can lead to profit or loss for investors, depending on interest rate movements.

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Floating Rate Bonds In India

Floating-rate bonds in India are popular because they provide a buffer against interest rate changes. Essentially, they’re like loans with variable interest, often issued by entities like the RBI or large corporations. Their interest rates align with the RBI’s repo rate, meaning they adjust as this base rate shifts. Consequently, investors in these bonds receive returns that reflect prevailing market conditions.

Floating Rate Bonds Example

Imagine an investor, Mrs. Mehta. She decides to invest in an RBI Floating Rate Bond. This bond’s interest rate is linked to the National Savings Certificate (NSC) rate with an added spread of 0.35%. If the NSC rate is 5%, Mrs. Mehta will earn an interest rate of 5.35% for the next interest period.

However, if the NSC rate rises or falls in the subsequent period, her interest earnings will adjust accordingly, ensuring she benefits from or is protected against the prevailing market rates.

Types Of Floating Rate Bonds

There are different kinds of floating-rate bonds: 

  • Floating-to-Fixed Rate Bonds
  • Inverse Floating-Rate Bonds
  • Step-up Callable Bonds
  • Perpetual Floating-Rate Bonds
  • Floating-to-Fixed Rate Bonds:

At first, the interest rate on these bonds is variable, but it will become fixed on a certain date. They are ideal for investors anticipating a decline in interest rates, as they guarantee a higher fixed interest rate for the fixed period.

  • Inverse Floating-Rate Bonds:

The interest rate on these bonds behaves opposite to a benchmark rate. In other words, when the benchmark rate rises, the bond’s rate falls, and vice versa. Investors expecting a drop in interest rates may find these bonds appealing as they may yield higher returns in such scenarios.

  • Step-up Callable Bonds:

There is a set rate schedule for these bonds that goes up over time. The issuers can buy back these bonds on certain dates, often the same as the step-up dates. Rising interest rates are good for investors, but they also come with call risk if the issuer decides to redeem the bonds early. 

  • Perpetual Floating-Rate Bonds: 

These bonds do not have an end date, so they keep paying interest forever. Usually, the rate changes based on a benchmark rate. They might appeal to investors who want a steady income stream, but they have a higher credit risk and price volatility than bonds with a set maturity date.

Fixed Rate Bond Vs Floating Rate Bond

The main difference between fixed-rate bond vs floating rate bond is that fixed rate bond has an interest rate that remains constant throughout its tenure.  In contrast, a floating-rate bond’s interest rate is linked to a benchmark, like a bank or treasury rate, and changes regularly based on the market. 

ParameterFixed Rate BondFloating Rate Bond
Interest RateRemains constant throughout the bond’s tenure.Adjusts periodically based on a reference rate.
RiskInterest rate risk is higher.Lower interest rate risk due to periodic adjustments.
ReturnsPredictable returns.Returns vary based on market interest rate movements.
Market Price VolatilityMore susceptible to price fluctuations.Lesser price volatility due to interest rate resets.
SuitabilityBest for investors seeking fixed returns.Ideal for those looking to benefit from rising rates.

Floating Rate Bonds Advantages And Disadvantages

The primary advantage of floating rate bonds is their ability to offer protection against interest rate volatility. As rates rise, the interest payouts of these bonds increase, ensuring that investors don’t lose out on potentially higher returns. 

Other advantages are as follows:

  • Market-Linked Returns:

The returns on these bonds are aligned with prevailing market rates. This alignment can be favorable in a thriving economic environment where interest rates are upward, ensuring that investors partake in the broader market gains.

  • Reduced Price Volatility:

Interest rates are reset regularly, which helps to keep the price of floating-rate bonds stable. This makes them less likely to go up or down in value than fixed-rate bonds. This is especially helpful when interest rates are going up, and the prices of fixed-rate bonds are going down.

  • Diversification:

Incorporating floating-rate bonds into a portfolio can enhance diversification due to their distinct risk-return profile. They respond differently to economic and market changes compared to fixed-rate bonds, offering risk mitigation and a potential enhancement in the overall portfolio performance.

  • Potential for Higher Returns:

In a scenario where interest rates are climbing, floating-rate bonds can provide superior returns compared to fixed-rate bonds whose interest payments remain static.

The primary disadvantage is the unpredictability of returns. If market rates decline, so will the returns on these bonds, potentially making them less attractive than fixed-rate bonds.

  • Complexity:

The process behind interest rate resets can be hard to understand, especially for people new to investing. A more in-depth understanding of the link between the benchmark rate, the spread, and how often the rate changes could be a problem for some investors. 

  • Potential for Lower Returns:

If interest rates go down, the returns on floating-rate bonds might go down, making them less profitable than fixed-rate bonds. This downside risk is a big worry because it could cause the value of the investment to drop over time, especially if market rates drop a lot. 

We hope that you are clear about the topic. But there is more to learn and explore when it comes to the stock market, commodity and hence we bring you the important topics and areas that you should know: