Floating Rate Bonds

Floating rate bonds pay interest at a rate that changes according to a selected benchmark. When the benchmark rises, the interest payment may increase. When it falls, the payment may decrease.

• Governments and companies can issue floating rate bonds.
• The interest rate is usually reset at fixed intervals.
• The rate may include a fixed margin over the benchmark.
• These bonds may reduce the impact of rising interest rates.
• Returns are less predictable than those from fixed-rate bonds.
• Corporate floating rate bonds may carry credit and liquidity risks.
   

Floating rate bonds are debt instruments that do not pay the same interest rate throughout their term. Instead, the interest rate changes according to a benchmark selected by the issuer.
The benchmark may be the RBI repo rate, MIBOR or another market-linked rate. The rate is reviewed and reset at intervals mentioned in the bond terms.
Because the interest rate changes, the income from these bonds may increase when benchmark rates rise. It may also decrease when benchmark rates fall.
 

Floating rate bonds link their interest payments to a benchmark rate. A fixed margin, also known as a spread, may be added to this benchmark.
For example, suppose a bond pays the benchmark rate plus a margin of 2%. If the benchmark rate is 6%, the bond’s interest rate will be 8%.
If the benchmark later rises to 7%, the bond’s rate will become 9% at the next reset. Similarly, if the benchmark falls, the bond’s interest rate will also decrease.
The reset period may differ between bonds. Investors should check the bond terms to understand how often the rate changes.
 

Floating rate bonds in India may be issued by the government or by companies. They may be available through banks, financial institutions, authorised brokers or approved bond platforms.

The investment process depends on the type of bond and how it is issued. Some bonds may need to be held in a Demat account, while others may be held in another permitted electronic form.

Before investing, you should review the issuer, interest-rate benchmark, reset period, maturity period and applicable risks.

Consider a floating rate bond whose interest is linked to a benchmark plus a margin of 2%.
If the benchmark rate is 6%, the bond will pay an interest rate of 8%. If the benchmark increases to 7%, the bond’s interest rate will become 9% at the next reset.
However, the opposite also applies. If the benchmark decreases to 5%, the bond’s interest rate will fall to 7%.
This example shows how the interest income from a floating rate bond changes with the benchmark rate.
 

Floating rate bonds can be classified according to their issuer and the method used to calculate interest.

• Government-issued FRNs: These bonds are issued or backed by the government. They generally carry lower credit risk than corporate bonds, although other risks may still apply.
• Corporate-issued FRNs: These bonds are issued by companies. They may offer different interest rates but also carry credit risk based on the financial position of the issuer.
• Benchmark-based FRNs: The interest rate on these bonds is linked to a stated benchmark, such as the RBI repo rate, MIBOR or another applicable rate.

• Fixed-margin FRNs: These bonds pay the benchmark rate plus a fixed margin. The margin normally remains unchanged, while the benchmark rate moves up or down.

  
  

Understanding these classifications can help you compare different bonds based on your financial goals and ability to accept risk.

Floating rate bonds may offer the following advantages:

• Adjustment to rising rates: Interest payments may increase when the linked benchmark rate rises.
• Market-linked interest: The coupon rate is reviewed periodically and reflects changes in the selected benchmark.
• Portfolio diversification: These bonds may add another type of fixed-income instrument to an investment portfolio.

• Lower credit risk in government bonds: Government-issued floating rate bonds generally carry lower credit risk than corporate-issued bonds.

  
  
  

Floating rate bonds also have certain limitations:

• Uncertain interest income: The interest payment may decrease when the benchmark rate falls.
• More complex calculations: New investors may find benchmark rates, spreads and reset periods difficult to understand.
• Lower predictability: Unlike a fixed-rate bond, a floating rate bond does not provide the same interest rate throughout its term.

• Liquidity risk: Some corporate floating rate bonds may not be traded frequently, making them difficult to sell before maturity.

  
  
  

Floating rate bonds pay interest that changes with a selected benchmark. They may be useful when market interest rates rise, but their income can decrease when rates fall. Government and corporate floating rate bonds also carry different levels of credit and liquidity risk. Before investing, check the benchmark, fixed margin, reset period, maturity and issuer’s financial position to understand whether the bond is suitable for your financial goals.