Floating-Rate Bond: Definition, Example, And Benefits
In today's dynamic financial landscape, investors constantly seek opportunities to optimise their returns while minimising risks. One such investment option introduced recently in the Indian financial system is floating-rate bonds1. These bonds present a unique opportunity to capitalise on interest rate fluctuations, providing investors with a flexible and potentially lucrative investment option. In this blog post, we will delve into floating rate bonds, exploring their key features, benefits, and strategies for capitalising on interest rate fluctuations.
What Are Floating-Rate Bonds?
Floating-rate bonds carry a coupon rate that is not fixed but linked to a benchmark rate such as the repo rate, LIBOR, etc. If the benchmark rate increases, the floating bond coupon rate increases, and vice versa. The magnitude of change is based on a predetermined formula. Governments, financial institutions, and corporations issue Floating-rate bonds. Coupon payments are made quarterly, semi-annually, or annually, depending on the bond terms.
To understand the concept of floating-rate bonds, consider a floating-fate home loan linked to a repo rate. You must pay a higher interest rate whenever the repo rate rises, resulting in a higher EMI. Similarly, as an investor, you can gain or lose from any coupon rate changes until the bond matures.
Mechanics Of Floating-Rate Bonds
Floating rate bonds involve the following elements:
Coupon Rate: A floating-rate bond’s interest rate is linked to an external benchmark interest rate plus the spread. In India, these rates are usually linked to a benchmark, such as the repo rate, reverse repo rate, or rate on National Savings Certificates or T-bills. Globally, this benchmark includes the Federal Reserve Funds Rate, LIBOR, US Treasury Note Rate, or Prime Rate. As market interest rates fluctuate, the interest payments on these bonds adjust accordingly.
Coupon Reset: The interest rate of a floating rate bond is reset periodically, quarterly, or semi-annually. The reset is based on a predetermined formula linked to the chosen benchmark rate.
Interest Payments: The interest payments on a floating rate bond are calculated by applying the prevailing interest rate to the bond's outstanding principal amount, which is paid quarterly, semi-annually, or annually. This results in variable interest payments over the bond's life.
Key Features Of Floating-Rate Bonds
Below are the two key features that make floating bonds set apart from traditional fixed-rate bonds:
Variable Interest Rates: Unlike fixed-rate bonds, floating-rate bonds have interest rates that adjust periodically.
Interest Rate Protection: Floating-rate bonds offer protection against rising interest rates. When market rates increase, the interest payments on these bonds also rise, ensuring that investors receive higher yields.
How Do Floating Rate Bonds Work?
In the case of fixed-rate bonds, the bond price falls whenever the interest rate rises, reflecting a new higher bond yield. On the other hand, floating-rate bonds are linked to the market rates and have variable coupons. Whenever the interest rates change, the coupon rate changes, thereby not impacting the bond prices.
Unlike fixed deposits, which give you a fixed interest rate for the complete tenure, floating bonds are sensitive to interest rate fluctuation. The bond's term is fixed, like in the case of RBI floating-rate bonds, for 7 years from the issue date. There is a provision for premature redemption for senior citizens depending on their age. Otherwise, you might have to pay a penalty for premature encashment.
Example To Understand The Concept Of Floating-Rate Bonds
The RBI’s floating-rate bonds are linked to the National Savings Certificate (NSC) interest rate, with a spread of 0.35% higher than the NSC Interest Rate. The following is the history of interest rates on NSCs and linked floating bond rates, which are revised every six months if the NSC interest rate changes.
Suppose you bought RBI’s floating-rate bond on 01 July 2020 for INR 100,000 with a floating coupon rate paid semi-annually. As per the above rate chart, you will get 7.15% semi-annually, INR 7,150/2 = INR 3,575 at the end of every six months in January and July. This amount will change for the Jan-Jun 2023 period when you will get INR 7,350/2 = INR 3,675 and further change in the July-Dec 2023 period when you will get INR 8,050/2 = INR 4,025. So with the NSC Interest Rate change, your coupon payments also change.
Benefits Of Investing In Floating-Rate Bonds
Investing in floating-rate bonds offers several benefits:
Interest Rate Hedge: Floating-rate bonds hedge against rising interest rates. As rates increase, the bond's coupon payments rise, providing investors with higher yields and protecting their investment value.
Credit Quality and Safety: Governments and creditworthy corporations often issue Floating-rate bonds, reducing the risk of default.
Low Volatility: A floating-rate bond is linked to market interest rates. Any change in market interest rates leads to a change in coupon rates, leaving the bond prices unchanged.
Higher Returns: Floating bonds offer higher returns than fixed-income instruments when interest rates are trending.
Diversification: Investing in floating-rate bonds provides investors with diversification opportunities when interest rates are low and expected to rise.
Strategies For Capitalising On Interest Rate Fluctuations
Interest rate fluctuations, while adding risk to an investor’s portfolio, can also present an opportunity to maximise the returns. The following strategies can help investors achieve this:
Yield Curve Positioning: Analyse the shape of the yield curve to help you predict interest rate movements. If the market interest rates are on an uptrend, you can strategically allocate a significant portion of the portfolio to floating-rate bonds.
Active Portfolio Management: You should regularly review and adjust your portfolio allocations based on interest rate trends to optimise returns and manage risk.
Diversification: Diversify investments across different industries and issuers to spread risk and mitigate the impact of any individual bond's credit or interest rate fluctuations.
Conclusion
Floating-rate bonds are an excellent hedging instrument to protect against market rate interest variation, especially when on an uptrend. They help you capitalise on interest rate fluctuations, offer interest rate protection, and potentially higher yields. However, they will not be helpful in falling markets.
You must conduct research, assess credit ratings, and perform financial analysis. Numerous factors influence interest rate movements and can be challenging to predict accurately. You should carefully analyse yield curve positioning and market trends and actively manage your allocation to floating-rate bonds, optimising returns while effectively managing risk.
References:
- Reserve Bank of India <https://tinyurl.com/upwv58ch>
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