Governments and private companies are in constant need of funds for new projects. While the government could be building new infrastructure for the economy, companies try to expand into new products or markets. It is not always possible to fund all the expenses from the earnings. Borrowing from banks come with an array of restrictions. In this scenario, the government or the company turns to the public to raise debt.
Bonds and debentures are the most common instruments used to borrow from the market. Bonds are categorised as fixed and floating rate bonds based on whether the rate of interest rate (or coupon rate) is fixed for the entire tenure or depends upon a benchmark interest rate (defined at the time of bond issuance).
What is a floating rate bond?
A bond is a debt instrument issued by a company or government to raise funds. When you buy a bond, you agree to receive periodic interest payments and a principal amount called the “face value” at its maturity. The interest rate of a bond can be fixed or floating.
Bonds typically have a predetermined coupon or interest rate. For instance, you may purchase a bond for Rs. 20,000 with a 5% coupon rate. In the case of such a bond, the bond issuer will pay you Rs. 1,000 as interest each year. This interest is fixed and does not change basis the market’s current interest rate.
However, in the case of a floating rate bond, the interest rate is a variab le. The interest rate of a floating rate bond is linked to a benchmark rate decided at the time of bond issuance. This interest rate is revised quarterly, half-yearly or annually as announced at the time of bond issue.
How do floating rate bonds work?
As discussed above, a floating bond pays a variable interest rate that is linked to a benchmark interest rate. The benchmarks that are most commonly used in India are repo and reverse repo rates.
For fixed coupon (interest) rate bonds, when the market interest rates increase, the bond prices fall to match the yield of the current bonds. In the case of floating rate bonds, the coupon rates move up or down with the market interest rates without much impact on the bond price. It is especially beneficial to buy floating rate bonds when you expect the market interest rates to go up.
Due to their peculiar nature, there are both advantages and disadvantages to investing in floating rate bonds.
Advantages of Investing in a Floating Rate Bond
Market prices are subject to lower volatility
The prices of floating rate bonds are relatively less volatile as compared to fixed-rate bonds. This is because, while in fixed rate bonds, the bond prices have to adjust as per market interest rates and yield; in the case of floating rate bonds, the interest rates get adjusted due to their pegging with a market benchmark. The bond prices, therefore, remain less affected by any market changes.
The returns from floating rate bonds come from coupon payments and any discount/premium to the face value at which you might have purchased them. In an increasing interest rate environment, the returns are usually higher than other fixed return instruments. Also, due to a spread above the benchmark rate, the returns from floating rates turn out to be high.
Floating rate bonds are usually issued by government bodies. Therefore, the likelihood of default is negligible.
From a macroeconomic perspective, an inverse relationship is seen between stock market performance and interest rates. Floating rate bonds can balance the risk profile of your portfolio. Those looking to diversify their investments can invest in these bonds to earn decent returns with low risk.
Disadvantages to Investing in Floating Rate Bonds
The interest rates of floating rate bonds move with the market-linked benchmark. As a result, a fall in interest rates could lower the yield of the bond in comparison to a fixed interest rate bond.
Interest rate risk
There could be a lag between market interest rate changes and the benchmark rate. This, in turn, would mean that the coupon payment on floating rate bonds continues to receive lower interest than the market rates.
When the government is the issuer, this risk is greatly mitigated. Bonds, being a debt instrument, always carry a risk of a payment default. As a bondholder, you should continuously monitor the creditworthiness of the issuers of the bonds you hold.
Interest Rate on RBI Floating Rate Bonds
Let’s look at an example of a floating rate bond recently issued by the RBI. The bond was announced in June 2020 and was available for investment from July 1st, 2020. The coupon rate of the bond was pegged to the interest rate of the National Savings Certificate (virable component) with a spread of 35 basis points (fixed component) higher than it.
RBI announces rate of interest on Government of India Floating Rate Bonds, 2024
The benchmark here is the interest rate on the National Savings Certificate. The coupon rate on the bond is reset every six months to match the movements in the NSC. For example, the current NSC interest rate is 6.8%. Therefore, the coupon rate is 6.8 + 0.35 = 7.15%.
How to Buy a Floating Rate Bond
For Government issued bonds: You can buy RBI-issued bonds online through RBI Retail Direct or NSEGoBid platforms. You must have a Demat account to invest in bonds. You will have to register on these platforms and submit your KYC documents. Then, you can buy/sell floating bonds by making payments via the bank account linked to your Demat account.
There is also an option to buy these bonds offline by submitting an application to SBI or other nationalised banks authorised by the RBI to sell these bonds.
Corporate Bonds: You can buy/sell corporate bonds through your broker account linked to your Demat. The bonds have scrip codes and can be bought just like stocks. There is also an option to directly buy some bonds from the exchanges’ websites.
Before buying bonds, the most important thing to check is the creditworthiness of the issuer. The creditworthiness is determined by the ratings provided by SEBI-registered credit rating agencies such as CRISIL, ICRA and CARE.
Floating rate bonds offer the investor exposure to the market interest rates as they are pegged to a benchmark. The exposure comes with both pros and cons. While you cannot predict the total return of a floating rate instrument, you should try to time your investments to benefit from macroeconomic trends, that is, invest in them if you think that interest rates are going to increase soon. Also, it is important to check the credit rating of the issuer before deciding to invest.
What is the difference between fixed rate bonds and floating rate bonds?
The interest rate on fixed rate bonds is fixed, that is, it remains constant throughout the entire tenure of the bond. On the other hand, the interest rate on floating rate bonds is pegged to a benchmark rate (there is a fixed and a variable component). It changes as the benchmark rate changes. For example, the interest rate for RBI floating rate savings bonds is linked to the interest rate on the National Savings Certificate (NSC).
What are the minimum and maximum amounts of investment in the RBI floating rate savings bonds?
You can invest a minimum of Rs. 1,000 in the floating rate bond issued by the RBI. There is no upper limit on the amount invested in the bonds.
What is the tenure of the RBI floating rate savings bonds?
The tenure of the RBI floating rate savings bond is seven years.
Are floating rate bonds a good investment?
Floating rate bonds are a good investment, especially when interest rates are expected to increase. While no one can predict the total return of a floating rate bond, they usually have high returns compared to many other instruments.
What is the best time to invest in floating rate bonds?
Since the interest rate on floating rate bonds is pegged to a benchmark rate, it is better to invest in floating rate bonds when the market interest rates are expected to increase.