What are floating rate bonds?

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Businesses can manufacture efficient products, provide quality services and ensure that their customer experience is supreme. However, one thing that is usually missing when looking at the success of a business is its cash flow or the amount of capital it has to grow. Expansion is the fundamental factor for a company to ensure its sustainability and increased profitability. If a business does not grow, it stagnates as competitors find new customers, new territories, and new opportunities to grow their business. Another factor that is influenced by the expansion of a company is its stock price. If investors see no growth potential for a company in the near term, they avoid buying its shares, causing prices to trade sideways.

For a business to grow, the most important thing is capital. Expansion requires opening a new factory, purchasing new equipment, hiring new employees, and investing in marketing or advertising. To ensure that the company has the necessary capital, it can either borrow from banks, raise capital through an IPO, or issue bonds.

This blog details the latest option where the company issues bonds to raise capital and cover current or future expenses of the company.

What are bonds?

Bonds are debt instruments, which implies that they operate on the principle of loans, where a company issues bonds to borrow money from the lender, also known as a bondholder. The company promises the lender a predetermined regular interest on the principal amount. In bond terms, this interest rate is called a coupon. However, some bonds do not have a fixed coupon rate because it fluctuates according to several predetermined benchmarks. These types of bonds are known as floating rate bonds.

How do bond yields fall and rise?

As with most things in the secondary market, bond yields also depend on the balance of supply and demand. Bond yields have an inverse relationship with bond prices. For example, if you have a bond with a maturity of 5 years, a coupon rate of 5% and a face value of Rs 10,000. Every year, the bond will pay you interest of Rs 500. Now, if the rates market interest rates exceed 5%, investors will not buy your bonds but will buy the new ones with an interest rate above 5%.

As a result, you will have to lower the price of your bond to increase its yield. When you lower the price, the coupon rate increases due to the lower face value, thus increasing the yield of the bond.

This is how bond yields fall and rise with prevailing market interest rates.

What are floating rate bonds?

Generally, bonds come with a fixed coupon or interest rate. For example, you can buy a bond of Rs 10,000 with a coupon rate of 5%. In the case of such a bond, you will receive an annual interest amount of Rs 500 from the issuer of the bond. This interest is constant and does not fluctuate with the current market interest rate.>

However, a floating rate bond is a debt instrument that does not have a fixed coupon rate, but its interest rate fluctuates according to the benchmark index on which the bond is drawn. Benchmarks are market instruments that influence the global economy. For example, the repo rate or the reverse repo rate can be set as benchmarks for a floating rate bond.

How do floating rate bonds work?

Floating rate bonds make up a significant portion of the Indian bond market and are mostly issued by the government. For example, the RBI issued a floating rate note in 2020 with interest payable every six months. After six months, the interest rate is reset by the RBI. The floating rate bond’s benchmark is 35 points above the prevailing National Savings Certificate (NSC) interest rate.

The current interest rate for the National Savings Bond is 6.8%. Therefore, the interest rate of RBI Floating Rate Notes is 6.8% + 0.35% = 7.15%.

Typically, a floating rate bond is issued by government, financial institutions, and corporations with a maturity of two to five years. Depending on a floating bond rate, its interest payment time can be quarterly, semi-annually or annually.

What are the different classifications of a floating rate bond?

A floating rate bond is mainly classified into two types:

  • Variable rate redeemable bonds: A floating rate callable bond allows the bond issuer to call the floating rate bond. This means that the issuer stops paying interest to the bondholder after repaying the original principal amount. These types of floating rate bonds ensure that the issuer is protected against falling/rising interest rates and can redeem the bond before maturity.
  • Non-redeemable floating rate bonds: These types of floating rate bonds do not offer the issuer the option of calling the bond or withdrawing the instrument prior to maturity. For these bonds, the issuer is required to pay the interest rate derived from the underlying benchmark index even if it has to incur a loss after paying the interest.

Advantages and disadvantages of floating rate bonds

Investors buy floating rate bonds because of their flexibility to reflect the current market interest rate. If the interest rate of the benchmark index increases, the interest rate payable for the floating rate note also increases. However, as is the case with any other debt instrument, floating rate bonds in India are also not without drawbacks.

Advantages

Here are the advantages of floating rate bonds:

  • Less volatility: Because floating rate bonds can adjust to market interest rates, they are less exposed to volatility or negative price movements. Traditional fixed rate bonds begin to show lower yields when the market interest rate drops.
  • Higher yields: The returns provided by floating rate bonds are higher than those of many other financial instruments. Additionally, if market interest rates rise, floating rate bonds can offer significant returns to the bondholder.
  • Safe investments: Investors looking to protect their investments, while seeking a high interest yield, can purchase government-issued floating rate bonds. These types of bonds are benchmarked against government instruments such as repo rates and are safer because there is no credit risk. Government-issued bonds have a negligible chance of defaulting on interest payments.
  • Diversification: Investors looking to diversify across different asset classes can invest in floating rate notes when market interest rates are low and expected to rise over time. As rates increase, the amount of interest payable will also increase, with the amount of principal being the same.

Disadvantages

Here are the disadvantages of floating rate bonds:

  • Lower yield: Floating rate bonds may end up earning the investor a lower return than fixed rate bonds because they are tied to a benchmark with a short term rate. If the short-term benchmark rate falls, floating rate notes may offer lower returns to the investor.
  • Interest rate risk: There is no guarantee that the interest rate of a variable rate obligation will increase with the same intensity as the market interest rate in a rising environment. Therefore, the bondholder may incur interest rate risk from underperformance of the bond relative to market interest rates.
  • Default risk: Floating rate bonds carry a risk of default because the institution may not pay the interest due to a lack of funds. If this happens, investors may suffer a loss related to the amount of principal and future interest payments.
  • Appeal risk: If investors buy a floating rate callable bond, they run the risk that the bond will be called back by the issuer. Although investors get their principal back, they lose out on future interest payments.

Floating rate bonds are a great way to earn a high amount of interest if you think market interest rates may rise soon. However, as floating rate bonds also come with certain risks, it is always best to consult a financial adviser before buying a floating rate bond in India. Now that you know the definition of floating rate bonds, you can consider diversifying your portfolio by buying floating rate bonds.

You can also consult with IIFL financial advisors to discuss various financial strategies and make informed decisions based on valuable information. Financial advisors will allow you to choose from a variety of floating rate bonds available and earn the highest possible return based on their benchmark instrument. Visit the IIFL website or download the IIFL Markets app from the App Store to learn more about bonds and how they can help you increase your profits and manage the health of your portfolio.

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