Businesses can make efficient products, provide quality service, and ensure their customer experience is supreme. However, one thing that is usually missing when looking at a business’s success is its cash flow or the capital it has available to grow. Expansion is the fundamental factor for a business to ensure sustainability and increased profitability. If a business does not grow, it stagnates when its competitors find new customers, new territories and new opportunities to grow their business. Another factor that is influenced by the expansion of a business is its share price. If investors do not see any growth potential for a company in the short term, they avoid buying its shares, which causes prices to move 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 last option where the company issues bonds to raise capital and cover the current or future expenses of the company.
What are Bonds?
Bonds are debt instruments, which implies that they work on the principle of loans, where a company issues bonds to borrow money from the lender, also known as a bond. 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 based on several predetermined benchmarks. These types of bonds are called 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 10,000 rupees. Each year, the bond will earn you interest of Rs 500. Now, if the interest rates in the market exceed 5%, investors will not buy your bonds but will buy the new ones with an interest rate greater than 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 bond’s yield.
This is how bond yields fall and rise according to prevailing market interest rates.
What are variable rate bonds?
Usually, bonds have a coupon or a fixed interest rate. For example, you can buy a bond for Rs 10,000 with a 5% coupon. In the event of such a bond, you will receive an annual interest amount of Rs 500 from the bond issuer. 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 depending on the benchmark against which the bond is drawn. Benchmarks are market instruments that influence the whole economy. For example, the reverse repo rate or reverse repo rate can be set as a benchmark for a floating rate bond.
How do floating rate bonds work?
Floating rate bonds are an important part of the Indian bond market and are mainly issued by the government. For example, the RBI issued a floating rate bond in 2020 with interest payable every six months. After six months, the interest rate is reset by the RBI. The benchmark index for the variable rate bond is 35 points higher than the interest rate of the national savings certificate (NSC) in force.
The current interest rate for the National Savings Bonus is 6.8%. Thus, the interest rate of the RBI variable rate bond 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 payable interest time can be quarterly, semi-annually or annually.
What are the different classifications of a variable rate bond?
A variable rate bond is mainly classified into two types:
1. Redeemable variable rate bonds: A callable variable rate bond allows the bond issuer to recall the variable rate bond. This means that the issuer stops paying interest to the bondholder after repaying the initial principal. These types of floating rate bonds ensure that the issuer is protected against falling / rising interest rates and can withdraw the bond prior to maturity.
2. Non-redeemable variable rate bonds: These types of floating rate bonds do not offer the issuer the option of recalling 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 even if it incurs 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 bond also increases. However, as with any other debt instrument, floating rate bonds in India are not without drawbacks either.
Here are the advantages of variable 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 start to show lower yields when the market interest rate drops.
- Higher returns: The returns provided by floating rate bonds are higher than those of many other financial instruments. In addition, if interest rates in the market rise, floating rate bonds can offer significant returns to the bond holder.
- Safe investments: Investors looking to protect their investments while looking to earn a high interest return can purchase government-issued floating rate bonds. These types of bonds have government instruments like the repo rate as a benchmark and are more secure because there is no credit risk. Government-issued bonds have a negligible chance of defaulting on interest.
- Diversification: Investors looking to diversify among various asset classes can invest in floating rate bonds when market interest rates are low and are expected to rise over time. As rates rise, the amount of interest payable will also increase, with the principal amount being the same.
Here are the downsides of variable rate bonds:
- Lower yield: Floating rate bonds may end up giving the investor a lower return than fixed rate bonds because they are pegged to a benchmark with a short term rate. If the short-term benchmark rate falls, floating rate bonds may offer lower returns to the investor.
- Interest rate risk: There is no promise that the interest rate on a floating rate bond will rise with the same intensity as the market interest rate in a bullish environment. As a result, the bondholder may experience an interest rate risk of underperforming the bond relative to market interest rates.
- Default risk: Floating rate bonds carry a risk of default as the institution may default on interest payments due to a lack of funds. If this happens, investors may suffer a loss related to the amount of principal and future interest payments.
- Risk of appeal: If investors buy a callable floating rate bond, they run the risk that the bond will be recalled by the issuer. Although investors are paid back their principal, they lose on future interest payments.
Floating rate bonds are a great way to earn a high amount of interest if you think market interest rates could go up soon. However, since floating rate bonds also come with certain risks, it is always best to consult a financial advisor before purchasing a floating rate bond in India. Now that you know the definition of floating rate bonds, you can consider diversifying your portfolio by purchasing variable rate bonds.
You can also consult with IIFR’s financial advisers to discuss various financial strategies and make informed decisions based on valuable information. Financial advisors will allow you to choose from a variety of variable rate bonds available and obtain the highest possible return based on their benchmark instrument. Visit the IIFR’s 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.
Frequently Asked Questions
Q.1: Do floating rate bonds carry interest rate risk?
Answer: Yes, floating rate bonds may present an interest rate risk. This is because the interest rate on the variable rate bond may not rise as quickly as market interest rates in a rising interest environment. It all depends entirely on the performance of the benchmark rate. If performance is not at par, the floating rate bond may underperform the overall market.
Q.2: How often are variable rates adjusted?
Reply : The adjustment time of any floating rate bond is pre-specified in the bond details. The adjustment time differs from one link to another. Some issuers adjust variable rates quarterly, some semi-annually, and others may adjust annually.