What are Floating Rate Bonds?

Businesses can make effective products, provide quality services and ensure their customer experience is supreme. However, one thing that is usually missing when looking at a company’s success is their cash flow or how much capital they have to expand. Expansion is the fundamental factor for a company to ensure sustainability and increased profitability. If a company does not expand, it becomes stagnant when its competitors find new customers, new territories, and new opportunities to grow their business. One more factor which is influenced by the expansion of a company is its stock price. If investors see no growth potential for a company shortly, they avoid buying its shares leading to the prices trading sideways.

For a company to expand, the most important thing is capital. Expansion requires opening a new factory, buying new equipment, hiring new employees, and investing in marketing or advertising. To ensure that the company has the needed capital, it can either borrow from the banks, raise capital through 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 called the bondholder. The company promises the lender a regular predetermined 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 as it fluctuates based on several predetermined benchmarks. These types of bonds are known as floating rate bonds.

How do bond yields fall and rise?

Similar to most things in the secondary market, bond yields also depend on the supply and demand equilibrium. Bonds yield has an inverse relationship with bond prices. For example, if you have a bond with a 5-year maturity, a 5% coupon rate, and a face value of Rs 10,000. Each year the bond will pay you interest of Rs 500. Now, if the interest rates in the market rise above 5%, investors will not buy your bonds but buy the new ones that come with an interest rate higher 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 because of the lower face value, thus increasing the bond’s yield.

This is how bond yields fall and rise based on the prevailing interest rates in the market.

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 be paid an annual interest amount of Rs 500 by the bond issuer. This interest is constant and does not fluctuate based on the current interest rate of the market.

However, a floating rate bond is a debt instrument that does not have a fixed coupon rate, but its interest rate fluctuates based on the benchmark the bond is drawn. Benchmarks are market instruments that influence the overall economy. For example, repo rate or 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 part of the Indian bond market and are majorly 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 re-fixed by the RBI. The benchmark for the floating rate bond is 35 points higher than the prevailing National Saving Certificate (NSC) interest rate.

The current interest rate for the National Savings Certificate is 6.8%. Hence, the interest rate for the RBI’s floating rate bond is 6.8% + .35% = 7.15%.

Generally, a floating rate bond is issued by the government, financial institutions, and corporations with two to five years of maturity. Depending on a floating bond rate, its interest payable time may 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:

• Callable Floating Rate Bonds: A callable floating-rate bond allows the issuer of the bond to call back the floating rate bond. It means that the issuer stops paying the interest to the bondholder after repaying the initial principal amount. These kinds of floating-rate bonds ensure that the issuer is protected against falling/rising interest rates and can retire the bond before maturity.
• Non-callable Floating Rate Bonds: These types of floating-rate bonds do not come with the option for the issuer to call back the bond or retire the instrument before maturity. For such bonds, the issuer is obliged to pay the interest rate derived from the underlying benchmark even if they have 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 interest rate of the market. If the interest rate of the benchmark rises, the interest rate payable for the floating rate bond rises too. However, as it is with any other debt instrument, floating-rate bonds in India are also not without their disadvantages.

Advantages

Here are the advantages of floating-rate bonds:

• Less Volatility: As floating rate bonds can adjust to the market interest rates, they have less exposure to volatility or negative price movement. Traditional fixed-rate bonds start showing lower yields when the market interest rate falls.
• Higher Returns: The returns provided by floating rate bonds are higher than many other financial instruments. Furthermore, if the interest rates in the market are rising, floating rate bonds can provide hefty returns to the bondholder
• Safe Investments: Investors looking to safeguard their investments, yet looking to get a high return of interest can buy government-issued floating rate bonds. These types of bonds have government instruments such as repo rates as their benchmarks and are safer as there is no credit risk. Government-issued bonds have a negligible chance of defaulting on interest payments.
• Diversification: Investors looking to diversify among various asset classes can invest in floating-rate bonds when the market interest rates are low and expected to rise in some time. As the rates rise, the payable interest amount will rise, too, with the principal amount being the same.

Disadvantages

Here are the disadvantages of floating-rate bonds:

• Lower yield: Floating rate bonds may end up paying a lower yield to the investor than fixed-rate bonds as they are attached to a benchmark with a short-term rate. If the short-term benchmark rate falls, the floating rate bonds’ may provide lower returns to the investor.
• Interest rate risk: There is no promise that the interest rate of a floating rate bond will rise with the same intensity as the market interest rate in a rising environment. As a result, the bondholder may experience interest rate risk of the bond underperforming compared to the market interest rates.
• Default risk: Floating rate bonds come with default risk as the institution may default on the interest payments because of a lack of funds. If this happens, the investors may experience a loss related to the principal amount and future interest payments.
• Call risk: If investors buy a callable floating rate bond, they face the risk of the bond being called back by the issuer. Although the investors are paid their principal back, they lose on the future interest payments.

Floating rate bonds are a great way to realize a high amount of interest if you feel that the market interest rates may climb shortly. However, as floating rate bonds also pose some risks, it is always better that you consult a financial advisor before buying a floating rate bond in India. Now that you know the floating rate bond definition, you can consider diversifying your portfolio by buying floating rate bonds.

You can also consult the financial advisors at IIFL to discuss various financial strategies and make informed decisions based on valuable insights. The financial advisors will allow you to choose among various available floating-rate bonds and make the highest return possible based on their benchmark instrument. Visit IIFL’s website or download the IIFL Markets app from the app store to learn more about bonds and how they can allow you to increase your profits and manage portfolio health.