In today's dynamic financial landscape, investors constantly seek opportunities to optimise their returns while minimising risks. One such investment option introduced recently in the Indian financial system is Floating Rate Bonds. These bonds present a unique opportunity to capitalise on interest rate fluctuations, providing investors with a flexible and potentially lucrative investment option. In this blog post, we will delve into the concept of Floating Rate Bonds, exploring their key features, benefits, and strategies for capitalising on the fluctuations in interest rates.
Floating Rate Bonds carry a coupon rate that is not fixed but is linked to a benchmark rate such as Repo Rate, LIBOR, etc. If the benchmark rate increases, the floating bond coupon rate increases and vice versa. The magnitude of change is based on a predetermined formula. Governments, financial institutions, and corporations issue Floating Rate Bonds. Coupon payments are made quarterly, semi-annually, or annually, depending on the bond terms.
To understand the concept of Floating Rate Bonds, you can take an example of a Floating Rate Home Loan, which is linked to say Repo Rate. Whenever there is a rise in the Repo Rate, you must pay a higher interest rate resulting in a higher EMI. Similarly, as an investor, you can gain or lose from any coupon rate changes until the bond matures.
Floating Rate Bonds involve the following elements:
Coupon Rate: A Floating Rate Bond’s interest rate is linked to an external benchmark interest rate plus the spread. In India, these rates are usually linked to a benchmark, such as Repo Rate, Reverse Repo Rate, or Rate on National Savings Certificates or T-Bills. Globally, this benchmark includes Federal Reserve Funds Rate, LIBOR, US Treasury Note Rate, or Prime Rate. As market interest rates fluctuate, the interest payments on these bonds adjust accordingly.
Coupon Reset: A Floating Rate Bond's interest rate is reset periodically, quarterly, or semi-annually. The reset is based on a predetermined formula linked to the chosen benchmark rate.
Interest Payments: The interest payments on a Floating Rate Bond are calculated by applying the prevailing interest rate to the bond's outstanding principal amount and are paid quarterly, semi-annually, or annually. This results in variable interest payments over the bond's life.
Below are the two key features that make floating bonds set apart from traditional fixed-rate bonds:
Variable Interest Rates: Unlike fixed-rate bonds, Floating Rate Bonds have interest rates that adjust periodically.
Interest Rate Protection: Floating Rate Bonds offer protection against rising interest rates. When market rates increase, the interest payments on these bonds also rise, ensuring that investors receive higher yields.
In the case of fixed-rate bonds, the bond price falls whenever the interest rate rises, reflecting a new higher bond yield. On the other hand, Floating Rate Bonds being linked to the market rates have variable coupons. Whenever there is a change in the interest rates, there is a change in the coupon rate - thereby not impacting the bond prices.
Unlike fixed deposits, which give you a fixed interest rate for the complete tenure, floating bonds are sensitive to interest rate fluctuation. The bond's term is fixed, like in the case of RBI Floating Rate Bonds; it is for a period of 7 years from the date of issue. There is a provision for premature redemption for Senior Citizens depending on their age. Otherwise, you might have to pay a penalty for premature encashment.
The RBI’s Floating Rate Bonds are linked to the interest rate of the National Savings Certificate (NSC) with a spread of 0.35% higher than the NSC Interest Rate. Following is the history of interest rates on NSCs and linked Floating Bond Rates, revised every six months if there is a change in NSC Interest Rate.
Suppose you bought RBI’s Floating Rate Bond on 01 July 2020 for INR 100,000 with a floating coupon rate paid semi-annually. As per the above rate chart, you will get 7.15% semi-annually, INR 7,150/2 = INR 3,575 at the end of every six months in January and July. This amount will change for Jan-Jun 2023 period when you will get INR 7,350/2 = INR 3,675 and further change in July-Dec 2023 period when you will get INR 8,050/2 = INR 4,025. So with the NSC Interest Rate change, your coupon payments also change.
Investing in Floating Rate Bonds offers several benefits:
Interest Rate Hedge: Floating Rate Bonds hedge against rising interest rates. As rates increase, the bond's coupon payments rise, providing investors higher yields and protecting their investment value.
Credit Quality and Safety: Floating Rate Bonds are often issued by Governments and creditworthy corporations, reducing the risk of default.
Low Volatility: A Floating Rate Bond is linked to market interest rates. Any change in market interest rates leads to a change in coupon rates, leaving the bond prices unchanged.
Higher Returns: Floating bonds offer higher returns than other fixed-income instruments when there is an uptrend in interest rates.
Diversification: Investing in Floating Rate Bonds provides investors with diversification opportunities when the interest rates are low and expected to rise.
Interest rate fluctuations, while adding risk to an investor’s portfolio, can also present an opportunity to maximise the returns. The following strategies can help investors achieve this:
Yield Curve Positioning: Analyse the shape of the yield curve to help you predict interest rate movements. If the market interest rates are uptrend, you can strategically allocate a significant portion of the portfolio to Floating Rate Bonds.
Active Portfolio Management: You should regularly review and adjust your portfolio allocations based on interest rate trends to optimise returns and manage risk.
Diversification: Diversify investments across different industries and issuers to spread risk and mitigate the impact of any individual bond's credit or interest rate fluctuations.
Floating Rate Bonds are an excellent hedging instrument to protect against market rate interest variation, especially when on an uptrend. It helps you capitalise on interest rate fluctuations, offers interest rate protection and potentially higher yields. Though in falling markets, they will not be helpful.
You must conduct research, assess credit ratings, and do financial analysis. It is also important to note that numerous factors influence interest rate movements and can be challenging to predict accurately. You should carefully analyse yield curve positioning and market trends and actively manage their allocation to Floating Rate Bonds, optimising the returns while managing risk effectively.
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