Floating Rate Bonds are great for diversification in an investor’s portfolio. These bonds do not have a fixed interest rate in their investment tenure. At the same time, floating rate bonds have a reduced risk to the interest risk rate. Their varied characteristics, safety features and ability to give good returns makes them a good investment option for certain investors.
To understand more about how floating rate bonds work, their appeal to investors, risk and return on floating rate bonds, and their advantages and disadvantages let us start with understanding floating rate bonds.
What is a floating rate bond?
A floating rate bond, which is a debt instrument, pays variable interests throughout its investment tenure. Unlike the fixed rate bonds where the interest rates are fixed for the tenure, the interest rate for a floating rate bond keeps fluctuating. It is tied to a short-term benchmark rate in different countries such as Federal Reserve funds rate, LIBOR, RBI rates, or the prime rate.
The interest can be given quarterly, semi-annually, or annually depending on the bond terms. The interest rate is reset periodically depending on these. Floating rate bonds are taxable or tax-exempt depending on the government guidelines.
How do they work?
While buying floating rate bonds investors experience that these bonds have their certain terms which makes it important for the investor to understand this instrument completely before investing.
Most floating rate bonds require the investor to deposit a minimum amount when opening an account. The tenure of the bond is usually predetermined.
There are three essential things to be considered in floating rate bonds: the benchmark rate, the spread, the amount of shift in rate over and above the benchmark rate, and reset frequency at which period one is going to reset the benchmark.
Floating rate bonds help to mitigate interest rate risk to a great extent as a high floating rate means high returns. So, the best time to buy such bonds is when their rates are low and are expected to increase. The change in the interest rate is heavily dependent on the performance of the benchmark rates. This makes it difficult for investors to ascertain the final amount they would receive upon maturity of the bond.
Some floating rate bonds provide the option of taking interest at different points in the year, while others give the lump sum interest upon maturity of the bond. Some bonds allow the investors to choose between these two options.
To understand this well, here is an example of the Floating Rate Savings Bonds, 2020 (Taxable) launched by the Reserve Bank of India. (This is just an example. We do not advertise any instruments)
These bonds have been available for subscription in the market from July 1, 2020, at an interest rate of 7.15 per cent for the period of July 2021 to December 2021. The interest rate of these bonds is reset every six months, and interest will be payable every six months with no option of a cumulative basis. A minimum amount of 1000 rs and from there on in multiples of 1000 has to be invested with no maximum limit. The repayment tenure of these bonds is seven years from the date of the issue of bonds, with premature redemption available only for specific categories. The interest will be taxable for these particular bonds as per the income tax slab that will apply to the investor’s income.
Highlighting the three essential points mentioned above, the benchmark to which these floating interest rates are linked is National Savings Certificate (NSC). The changes in the NSC rate directly impact the interest rate of these bonds, the spread is over 0.35% over that NSC rate, and the impact can be seen every six months.
Advantages of Floating Rate Bonds
Floating rate bonds can be highly profitable when the overall market interest rates rise compared to fixed rate bonds where investors get the same interest despite the excellent market condition.
Floating rate bondsprotect an investor against an interest rate risk. As the interest rate on these bonds changes according to the resetting of the benchmark rates, these bonds suffer less from price volatility. Their price eventually remains steady over the years as they don’t suffer from interest rate changes.
Drawbacks of Floating Rate Bonds
Being a debt instrument, there is a specific default risk associated with floating rate bonds. Liquidation or bankruptcy can lead the bond issuer to default on the repayments making the investors suffer greatly.
If the interest rates in the market fall, it would lead to a reduction in the bond’s interest rate, leading to investors receiving less income.
There is a lack of certainty concerning predicting a constant income stream by investing infloating rate bonds. Its variable nature makes it less reliable if the investor plans to gain a steady income.
Bonds with a variable rate allow investors to gain income based on fluctuating benchmark rates. A floating rate bond is a good investment for risk-averse investors that plan to have a diversified portfolio rather than investing in only a few particular instruments. One should look at the organization’s background issuing these bonds to access their regular creditworthiness before investing. Investors should also focus on the taxation aspect to make sound investment choices. Overall, good research on the risk and returns of a particular floating rate bond coupled with proper planning to achieve one’s financial goals can yield good returns from the debt instruments.