While traditional bonds offer a stable interest rate, this also means that they may not be the best choice in a fluctuating interest rate environment. This is where an alternative debt instrument- a floating rate bond comes into play.
What is a Floating Rate Bond?
A floating interest rate bond, also known as a “floating rate note” or “floater,” is a type of debt security whose interest rate varies in response to market conditions.
The interest rate on a floating rate bond depends on a reference rate, such as the benchmark lending rate of the Reserve Bank of India, plus a fixed spread.
How does a Floating Rate Bond work?
Floating interest rate bonds have a variable interest rate that adjusts periodically. The rate on the bond will rise or fall in line with changes in the reference rate, providing some protection against inflation and interest rate risks.
For example, let’s say you invest in a floating interest rate bond with a face value of Rs. 10,000 and a coupon rate of 1% above the prevailing policy repo rate. At the time of purchase, the policy repo rate is 5%, which means the bond pays a coupon rate of 6% (5% + 1%); if the policy repo rate increases to 6%, the coupon rate on the bond will also increase to 7% (6% + 1%).
Conversely, if the policy repo rate decreases to 4%, the coupon rate on the bond will fall to 5% (4% + 1%). That means the value of your investment will be less sensitive to changes in interest rates than traditional fixed-rate bonds.
Classifications of a Floating Rate Bond
- Callable: Callable floating rate bonds are those the issuer can redeem before their maturity date, either partially or fully, at a pre-determined call price. That means if the interest rates in the market fall, the issuer can call back the bonds and re-issue them at a lower interest rate, reducing their borrowing cost.
This flexibility benefits the issuer but can disadvantage investors who may lose out on potential future interest earnings. In exchange for this feature, callable floating-rate bonds typically offer a higher interest rate.
- Non-callable: Non-callable floating rate bonds, as the name suggests, cannot be redeemed by the issuer before their maturity date. However, since they do not offer the flexibility of callable floating-rate bonds, their interest rates are typically lower.
Advantages of Floating Interest Rate Bond in India
- Less Volatility: These bonds can adjust to market interest rates, minimizing exposure to price volatility.
- Higher Returns: In rising-rate environments, floating rate bonds can provide substantial returns.
- Safety: Government-issued floating rate bonds carry minimal default risk.
Disadvantages of Floating Interest Rate Bond in India
- Lower Yields: They may offer lower yields than fixed-rate bonds due to short-term benchmark rates.
- Interest Rate Risk: There’s no guarantee that the bond’s interest rate will rise as quickly as market rates in rising environments.
- Default and Call Risk: Investors face the risk of default or the bond being called back by issuers.
In essence, floating rate bonds give investors an alternative option to conventional fixed-income investments, with the potential for increased returns in a rising interest rate climate.
FAQs| Floating Rate Bonds
Floating rate bonds feature variable interest rates that fluctuate based on specific benchmarks, while fixed-rate bonds have constant coupon rates.
Government-issued floating rate bonds are considered safe due to minimal default risk.
Investors should weigh the potential for higher returns against the risks, including interest rate risk and the issuer’s call risk.
Yes, investors can use floating-rate bonds to diversify their portfolios, particularly when expecting rising interest rates.
Interest payments on floating rate bonds can vary, with options for quarterly, semi-annual, or annual payments.
A 7.15% floating rate bond is a government-issued bond in India that pays a variable interest rate tied to the National Savings Certificate (NSC) rate. Its interest rate adjusts every six months, and the bond lasts for seven years. Introduced in July 2020, it replaced the discontinued 7.75% savings bonds.
Floating rate bonds, also known as floating rate notes (FRNs) or floaters, are bonds in India that offer variable interest rates linked to benchmark rates or indices. Entities like governments, PSUs, corporations, banks, and financial institutions issue them for fundraising. They provide benefits such as protection against interest rate fluctuations, lower coupon rates, and increased liquidity.
RBI floating bonds are issued by the Reserve Bank of India (RBI) and have variable interest rates tied to the repo rate. They don’t have a maturity date and were introduced as perpetual debt instruments for retail investors in June 2020. To purchase them, you can use nationalized banks like SBI, PNB, or BOB or online platforms like BondsIndia, Zerodha, or ICICI Direct. You’ll need a Demat account and a PAN card for the purchase.
Disclaimer: Investments in the securities market are subject to market risks; read all the related documents carefully before investing.