Floating Rate Bonds

 In the present environment of market fluctuations, it is important for investors to balance risk and return. One financial instrument that often plays a pivotal role is the floating rate fund. Unlike fixed-rate bonds that have a set interest rate, floating rate bonds adjust interest payouts based on benchmark rate changes.

Understanding Floating Rate Bonds

Floating rate bonds are debt instruments with variable interest rates that adjust periodically. The interest rates of these bonds are tied to a benchmark rate like the Reserve Bank of India (RBI) repo rate, Mumbai Interbank Offered Rate (MIBOR). The interest rate fluctuates with the benchmark rate, which is adjusted every three, six or twelve months.

One common example is the floating rate note. Financial institutions, governments or corporations issue these notes. If the note is issued according to a reference rate of the present MIBOR including a 0.5% margin, the interest that the investor receives will fluctuate with a change in MIBOR rate. 

How Do Floating Rate Funds Work?

Issued by the government, floating rate bonds constitute a large part of the bond market in India. Let us consider a floating rate bond as an example, which was issued by the RBI in 2020. The interest was to be paid semi-annually. After six months, the RBI readjusted the rate of interest. The benchmark for these bonds is 35 points higher than the prevailing National Saving Certificate (NSC) interest rate.

The current rate of interest for NSC is 6.8%. Therefore, the rate of interest for the bond issued by the RBI becomes 7.15% (6.8 + 0.35).

Floating rate bonds are issued by financial institutions with a maturity of at least two to five years. The time period in which the interest is payable varies according to the rate of interest.

4 Types of Floating Rate Bonds

Floating bonds are of the following types:

1. Floating-to-Fixed Rate Bonds: The rate of interest on such bonds is variable initially. However, it becomes fixed at a certain point in time. These bonds are suitable for you if you are awaiting interest rates to lower down. For a fixed period, these bonds guarantee a higher fixed rate of interest.
2. Perpetual Floating Rate Bonds: These bonds do not come with an end date. Generally, the rate of interest changes according to the benchmark rate. If you are an investor looking for a steady flow of income, then these bonds would be ideal for you. The credit risk involved is however on the higher end.
3. Inverse Floating Rate Bonds: In these bonds, the interest rate shifts opposite to the benchmark rates. When the benchmark rate increases, the rate of interest on these bonds falls and vice versa. If you are looking for a fall in interest rates as an investor, this might be beneficial to you. This is because, in such scenarios, the chances of getting high returns are more.
4. Step-up Callable Bonds: In the case of these bonds, there is a fixed schedule of rate. This rate increases with time. The issuer can buy back the bond on the step-up dates. The increase in interest rates is beneficial for the investors, but there is also a risk involved while investing in a floating fund. If you want to redeem the bonds early, there is a call risk.

Advantages of Floating Rate Bonds

Some benefits of investing in floating rate funds are:

1. Safe Investments:

Floating rate bonds are usually issued by the government. Therefore, if you are willing to protect your investment and yet looking for a higher return of interest, you can buy a floating rate fund. These bonds have zero credit risk involved. They have repo rates as their benchmarks. Bonds issued by the government also have lesser chances of fraudulent interest payments.

1. Higher Returns

Compared to most other financial instruments, these bonds offer much higher returns to you. Moreover, if the rate of interest in the market is on the rise, floating rate bonds can provide high returns to you.

1. Diversification

Investors often look for a diverse class of assets. If you are one such investor, you can invest in these bonds when the interest rates in the market are low and are likely to rise. With the rates eventually rising over time, the amount of interest rises too, the principal amount being the same.

1. Less Volatility

As the bonds are flexible enough to accommodate the market interest rates, they are less likely to be affected by price fluctuations. This is a contrast to fixed rate bonds which offer lower returns when the market interest rate drops.

When to Invest in Floating Rate Bonds?

Floating rate bonds adjust according to the interest rates in the market. They work based on benchmark rates. If the benchmark interest rate is on the rise, the rate of interest of the floating rate bond rises as well. Thus, such a situation presents a good opportunity for you to invest in floating rate bonds.

Additionally, in comparison with fixed deposits, these bonds have a higher rate of interest, thus guaranteeing higher returns. However, you should keep checking if the interest rates are dropping. If inflation is under check, in the following review cycle, the market rate of interest might fall.

Looking for investment options that align with changing interest rates? Visit Stable Money to explore curated bond opportunities and make informed decisions today!