Floating Rate Bonds

What are Floating Rate Bonds?

Floating rate bonds, also known as variable rate bonds, are debt instruments where the interest rate periodically adjusts based on a reference rate, such as the RBI's repo rate or the Mumbai Interbank Offered Rate (MIBOR).

These bonds offer investors protection against interest rate risk by adjusting the interest payments to prevailing market rates. Unlike fixed-rate bonds, which maintain a constant interest rate, floating rate bonds provide flexibility and adaptability to changing market conditions.

How Do Floating Rate Bonds Work?

Floating rate bonds operate by tying their interest rates to a benchmark rate, with an added spread determined at issuance. For example, if a bond is issued with an interest rate of MIBOR + 0.5%, and the MIBOR rate increases from 5% to 6%, the interest rate on the bond will adjust from 5.5% to 6.5%. This adjustment ensures that the bond's yield remains competitive with current market rates.

Example of a Floating Rate Note (FRN)

A common example of a floating rate bond is a Floating Rate Note (FRN). FRNs are typically issued by governments, corporations, or financial institutions. For instance, if an FRN is issued with a reference rate of the prevailing MIBOR rate plus a margin of 0.5%, the interest rate paid to investors will fluctuate in line with changes in the MIBOR rate.

Different Classifications of a Floating Rate Bond

Floating rate bonds can be classified based on various factors, including the frequency of interest rate adjustments, the reference rate used, or the issuer's credit quality. Some bonds may have quarterly, semi-annual, or annual interest rate resets, while others may reset monthly. Additionally, the spread over the reference rate may vary depending on the bond's risk profile and market conditions.

Advantages of Floating Rate Bonds

Interest Rate Risk Mitigation: Floating rate bonds offer protection against interest rate risk as their coupon payments adjust with changes in market rates.

Higher Potential Returns: In a rising interest rate environment, floating rate bonds may provide higher returns compared to fixed-rate bonds.

Liquidity: Due to their periodic interest rate adjustments, floating rate bonds may offer better liquidity than fixed-rate bonds.

Disadvantages of Floating Rate Bonds

Lower Initial Yields: Floating rate bonds often offer lower initial yields compared to fixed-rate bonds of similar maturity.

Uncertain Income: Investors may experience uncertainty in income as the interest payments fluctuate with changes in market rates.

Limited Availability: Floating rate bonds may be less commonly available than fixed-rate bonds, limiting investment options.

How to Invest in Floating Rate Bonds in India?

Investors can invest in floating rate bonds through various channels such as government bond auctions, primary bond markets, or bond mutual funds. It's essential to consider the credit quality of the issuer, the frequency of interest rate adjustments, and the liquidity of the bond before investing. Additionally, investors can consult financial advisors or brokerage firms for assistance in selecting suitable floating rate bond investments.

Floating rate bonds provide investors with a flexible investment option that adjusts to prevailing market interest rates. By offering protection against interest rate risk and potential for higher returns in rising rate environments, floating rate bonds can be valuable additions to diversified investment portfolios. However, investors should carefully assess their risk tolerance and investment objectives before investing in floating rate bonds.