Bonds are a type of debt instrument that loans money to the issuer. The issuer borrows money at a fixed or variable interest rate for a specific duration. The issuer can be government, banks or corporations. They can issue fixed-rate bonds or floating rate bonds. In this article, we will discuss floating rate bonds, their advantages and limitations, and how to invest in them.
What is Floating Rate Bonds?
A floating rate bond has a variable coupon payment which means that the interest rate fluctuates based on the benchmark rate reset at regular intervals. In simple words, the interest rate of a floating rate bond keeps fluctuating throughout its tenure. The benchmark varies for different countries like Federal Reserve Funds Rate, LIBOR, RBI rates or prime rate. In India, the repo rate or reverse repo rate is the benchmark for floating rate bonds.
Generally, governments, financial institutions and corporations issue these bonds to borrow money from the public. The interest on these bonds can be paid quarterly, half-yearly or annually, depending on the bond terms. Also, the interest rate is reset periodically based on the coupon payments.
To understand the floating rate bond better, you can draw its parallel with a floating rate home loan. Whenever the repo rates rise, you have to pay a higher interest rate (and EMI) and vice versa. Similarly, as an investor, you can benefit or lose out from any changes in coupon rates of floating rate bonds.
How Do Floating Rate Bonds Work?
For the regular bond funds, the bond price falls whenever the interest rate rises. It reflects a new higher bond yield. On the contrary, the floating rate bonds have floating coupons, which are in line with the market rates. Hence, whenever there is an increase in interest rates, only its coupon rates rise without correction in bond prices.
Thus, this gives better yields to the investor. Similarly, when the interest rates go down, the coupon rates also fall, reducing the yields to the investor. Therefore, investors can choose to invest in these bonds when the interest rates are low and will rise in the future. However, investors cannot ascertain the final amount they will receive upon maturity of the bond.
Let’s understand floating rate bonds with the help of an example. RBI issued a floating rate bond in 2020 with interest payable every six months. The interest rates will be reset by the RBI every six months. The benchmark for this floating rate bond is 35 points higher than the prevailing NSC interest rate. The repayment tenure for these bonds is 7 years from the issue date. The interest will be taxable per the individual’s income tax slab rate.
The current interest rate of NSC is 6.8%. Thus, the interest rate for RBI’s floating rate bond is 6.8% + .35 = 7.15%. Also, any changes in the NSC rate can directly impact the interest rate of these bonds, which can be seen every six months.
Advantages of Investing in a Floating Rate Bond
A floating rate bond pays interest in sync with the market interest rates. Hence, they have less exposure to volatility and negative price movement. On the other hand, stock market investments can be risky due to high market volatility.
These bonds can offer higher interest rates than any other fixed-income instruments. Also, when the interest rate is rising, they offer higher returns to the bondholder. In other words, they become profitable investments during the rising market interest rate scenario.
When the government issues floating rate bonds, they become safe investments with decent interest payments. These instruments have a repo rate as their benchmark and are safer as there is no credit risk. Furthermore, when the government issues bonds, there is a negligible chance of defaulting the interest payment. However, corporate bonds carry some risk, where risk can be managed by investing in high rated securities.
Investing in floating rate bonds helps investors diversify their portfolios among various asset classes, especially when the interest rates are low and expected to rise. As interest rates increase, coupon payments will also rise. Thus, investors can choose to invest in these funds with a tenure matching their financial goals that can help them develop a better financial plan.
Disadvantages of Investing in a Floating Rate Bond
Sometimes, a floating rate bond can pay a lower yield to investors than fixed-rate bonds because they are linked with the benchmark rate. If the benchmark rates fall, these bonds provide lower yields to the investors.
Interest rate risk
There is no guarantee that the interest rate of the bond will rise with the same intensity of the market rates in a rising environment. As a result, the bondholder may experience an interest risk, where the bond may be underperforming than the market interest rate.
Credit risk arises when the borrower is unable to repay the principal and interest amount. As a result, bondholders may experience a loss related to their investment. To reduce this risk, they can invest in high rated bonds or choose government-issued bonds with zero default risk.
How to Invest in a Floating Rate Bond in India?
In India, floating rate bonds can be issued by the government, corporations or financial institutions. You can invest in these bonds via primary market or secondary market. The following are different ways to invest in floating rate bonds in India –
- Firstly, you have to register on the platform with your KYC documents.
- After verification, you can select the bond available for subscription.
- Next, you have to make the online payment from the bank linked to your Demat account.
- You will receive the bonds in your demat account or available on the RBI direct platform.
Also, the government assigns official distributors and designated branches of banks and post offices where you can purchase these bonds. You will have to fill out an application form and submit it with the necessary documents. After the request is processed, you will receive the bond certificate.
By Corporations or Institutions
You can buy these corporate bonds in the primary market through a brokerage firm or a broker. Some of these bonds are also traded over the counter. You can purchase these bonds on the broker’s online platform. There are various online platforms that are available for investment in bonds like BondsIndia, GoldenPI, Zerodha, etc.
The bonds can also be bought through the stock exchanges in the secondary market. Each bond has a scrip code, just like shares. You can check with scrip code the current price of these bonds. Also, the bond yields are available on the exchange websites. Moreover, when corporations issue these bonds, it is essential to check the credit rating before investing in them. This helps to ascertain the creditworthiness of the issuer.