For large-scale initiatives, both public and private organizations usually require funding. Whether it’s the government building the country’s essential infrastructure or companies exploring new products or markets, their profits frequently don’t cover the costs. Conventional borrowing strategies, like applying for bank loans, may come with a lot of restrictions. In these situations, they use public instruments such as bonds (or Floating Rate Bonds) and debentures to leverage debt accumulation.
Bonds are essential among them, particularly floating rate bonds, where the interest rate or coupon rate can change depending on a benchmark. Based on how stable their interest rates are over the bond’s term, bonds can be broadly divided into fixed-rate and floating-rate bonds. In this blog, we will be talking about Floating Rate Bonds.
Understanding The Floating Rate Bond
Bonds typically have a fixed interest rate or coupon. For instance, you could purchase a Rs 10,000 bond with a 5% coupon rate. If such a bond is issued, the bond issuer will pay you 500 rupees in interest each year. This interest is fixed and does not change in response to the market’s current interest rate.
On the other hand, a floating rate bond is a type of financial instrument in which the interest rate is variable and determined by the benchmark against which the bond is drawn. Benchmarks are the market instruments that have an impact on the economy as a whole. For a variable rate bond, the repo rate or reverse repo rate can be used as a benchmark.
How Do Floating Rate Bonds Work?
A floating bond, as was previously mentioned, has an interest rate that fluctuates and is based on a benchmark rate. In India, the most widely used benchmarks are reverse repo rates and repo rates.
Bond prices for fixed coupon (interest) rate bonds decrease to match the yield of the current bonds as market interest rates rise. When it comes to floating rate bonds, the bond price is not significantly affected by the coupon rates’ fluctuations in line with market interest rates. Purchasing such bonds is particularly advantageous if you anticipate an increase in market interest rates.
Investing in floating-rate bonds has benefits and drawbacks because of their unique characteristics.
Types of Floating Bonds
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 denotes that following the repayment of the initial principal amount, the issuer ceases to pay interest to the bondholder. These specific floating-rate bonds guarantee that the bond issuer can retire the bond before maturity and is protected from rising or falling interest rates.
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. In the case of these bonds, the issuer must pay the interest rate that is based on the underlying benchmark, even if doing so results in a loss.
Read Also | Nifty 50 Gained Over 9% In Past 2 Months, Jumping to 18% year-to-date.
Advantages and Disadvantages of Floating Rate Bonds
Because FRB can be adjusted to reflect the current market interest rate, investors purchase them. The interest rate due for the floating rate bond increases in tandem with an increase in the benchmark’s interest rate. Nevertheless, these bonds in India have drawbacks just like any other type of debt instrument.
Advantages
The following are some benefits:
Less Volatility: Floating rate bonds are less susceptible to negative price movement or volatility because they can adjust to the market interest rates. The yield on conventional fixed-rate bonds decreases in tandem with a decline in the market interest rate.
Greater Returns: Compared to many other financial instruments, floating-rate bonds offer greater returns. Furthermore, F.R. bonds can give bondholders substantial returns if market interest rates are rising.
Safe Investments: Government-issued floating rate bonds are an excellent option for investors seeking to protect their money while still earning a high rate of return. These bonds are safer because there is no credit risk and they are benchmarked by government instruments like repo rates. There is very little possibility of an interest payment default on government-issued bonds.
Diversification: When market interest rates are low and predicted to rise shortly, investors who wish to diversify their holdings across several asset classes can purchase floating-rate bonds. The principal amount remains constant, but as interest rates rise, so will the amount of interest that must be paid.
Disadvantages
The following are the drawbacks:
Lower yield: Because F.R.B are tied to a benchmark with a short-term rate, they may wind up giving investors a lower yield than fixed-rate bonds. Investor returns on floating rate bonds could be reduced if the short-term benchmark rate declines.
Interest rate risk: In a rising environment, there is no guarantee that a floating rate bond’s interest rate will increase at the same pace as the market rate. The bondholder may thus be exposed to interest rate risk if the bond underperforms market interest rates.
Default risk: Because the institution might be unable to pay interest due to a lack of funds, floating rate bonds carry a default risk. The investors might suffer a loss on the principal amount and subsequent interest payments if this occurs.
Call risk: When purchasing a bond with a callable floating rate, investors run the chance of having the issuer call back the bond. The investors lose out on future interest payments even though their principal is returned.
Example
Let’s examine a recent RBI-issued floating rate bond as an example. The band went on sale on July 1st, 2020, after being announced in June of that same year. The coupon rate on the bond was set at a spread of 35 basis points (fixed component) above the interest rate of the National Savings Certificate (variable component).
RBI announces rate of interest on Government of India Floating Rate Bonds, 2024
Interest Rate
The interest rate on the National Savings Certificate serves as the benchmark mentioned above. Every six months, the bond’s coupon rate is reset to reflect changes in the NSC. For instance, the NSC interest rate as of right now is 6.8%. The coupon rate is 6.8 + 0.35 = 7.15% as a result.
How to Purchase a F.R.B for Bonds Issued by the Government
Through the platforms NSEGoBid and RBI Retail Direct, you can purchase bonds issued by the RBI online. To invest in bonds, you need to have a Demat account. You can create an account on these sites and send in your KYC paperwork. Next, you can use the bank account that is connected to your Demat account to make payments to buy or sell floating bonds.
By applying for SBI or other nationalized banks approved by the RBI to sell these bonds, buyers can also choose to purchase these bonds offline.
Corporate Bonds: Using the broker account connected to your Demat, you will be able to purchase and sell corporate bonds. The bonds can be purchased similarly to stocks and have scrip codes. Purchasing bonds directly from the websites of the exchanges is another option.
The most crucial thing to look into before purchasing bonds is the issuer’s creditworthiness. The ratings from SEBI-registered credit rating agencies like CRISIL, ICRA, and CARE are used to assess creditworthiness.
Read Also | Natural Gas Trading: Everything You Need To Know!
Conclusion
If you think that the market interest rates will rise soon, floating rate bonds are an excellent way to make a large amount of interest. Before purchasing a floating rate bond in India, you ought to consult with a financial advisor because these bonds carry some risk. Now that you are aware of the definition of a floating rate bond, you may want to think about purchasing some to diversify your holdings.