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Traditional investment instruments have constraints on returns, and modern instruments carry high-risk factors. Moreover, markets are increasingly becoming vulnerable to different aspects of the economy. The wars, inflation, demand and supply, etc, pose a great risk of fluctuations in the market.
The main objective of investors is beating the odds and earning returns till maturity. However, not all instruments are capable of combating market fluctuation. Floating rate bonds are an excellent solution to this problem. Explore the unique world of floating rate bonds with this article!
Understand the floating rate bonds.
As the name suggests, floating rate bonds are a debt instrument designed to manage market fluctuations with their unique features. There are mainly two types of bonds:
- Fixed rate bonds – The coupon rate as a % of the bond’s face value is fixed at the time of issue. Moreover, they offer low returns with low risk.
- Floating rate bonds – The coupon rate varies as per the variations in the benchmark for the bonds. They offer high returns with comparatively higher risk.
These are instruments with variable interest rates based on their benchmark. Their interest is revised annually, half-yearly, or quarterly. The floating rate bonds offer interest in the combination of – the base benchmark rate + the spread offered.
Floating rate bonds are mainly of four types:
- Floating-to-fixed rate bonds
In the starting years of the investment, the interest rate would be variable as the benchmark. However, after a certain period, these interest rates would become stable. If the benchmark associated with the bonds is expected to decline in future, then these bonds are a great source of returns.
- Inverse floating rate bonds
This is similar to – ‘betting against the market’. The interest rates of such bonds are exactly opposite to the benchmark rates. Investors with good market knowledge can only invest in them.
- Step-up callable bonds
The base rates of such bonds rise at a certain date, which offers a collectively higher return. However, these bonds can be redeemed by the issuers before maturity.
- Perpetual floating rate bonds
As the name suggests, these bonds eternally pay the fluctuating interest as per the benchmark. However, investors also consider the risk of getting stuck in stagnant returns in these bonds.
Must read: Government bonds in India – Meaning, types and features.
So, how do these bonds work?
Let us simplify the function of floating rate bonds in India with this example:
RBI issued ‘RBI Floating Rate Savings Bonds’ in 2020. The interest is paid in half-yearly in January and July. The benchmark for the instrument is the National Savings Certificate offered by the Indian post department. The RBI floating bond interest rate is 0.35%.
The usual concern of investors is – Being a retail investor, how to buy RBI floating rate bonds?’ The answer is RBI Retail-Direct. The process is explained in detail further in this article.
| Period | NSC interest rate | RBI Floating Rate Savings Bond |
| January- March [2022] | 6.8% | 7.15% |
| April-June [2022] | 6.8% | 7.15% |
| July-September [2022] | 6.8% | 7.15% |
| October-December [2022] | 6.8% | 7.15% |
| January- March [2023] | 7.0% | 7.35% |
| April-June [2023] | 7.7% | 8.05% |
| July-September [2023] | 7.7% | 8.05% |
| October-December [2023] | 7.7% | 8.05% |
| January- March [2024] | 7.7% | 8.05% |
| April-June [2024] | 7.7% | 8.05% |
Source: National Savings Institute
Features
- Benchmark
It is the instrument attached to the bond according to which the interest rates are determined. Over and above the interest rate of the benchmark, the interest rate is provided by the floating rate bonds. The convexity of floating rate bonds is high due to the benchmark security. These benchmarks can be any investment security in the market.
The interest rate comprises mainly two components- the base rate of the security and the return spread offered by the bond. These interest rates are paid to the investors annually, quarterly, or half-yearly.
The spread offered over the base return of the benchmark is the reward for the high risk of investment. The interest rates may stagnate in these bonds if the benchmark does not generate good returns. Moreover, investors have to wait till the periodic adjustment, which poses the risk of opportunity cost.
As previously discussed in the article, there are different types of floating rate bonds which have distinct maturity periods. RBI Floating Rate Savings bond has a fixed maturity period of 7 years. The early withdrawal is allowed with some penalty.
- Investment
The minimum investment in these bonds starts at Rs.1000/-. Further investment can be done in multiples of 1000/-.
Also, read about: The ‘Debt+Equity’ Jackpot: Partially convertible debentures.
Advantages & disadvantages
| Advantages | Disadvantages |
| The Floating rate bonds earn higher interest rates due to the spread provided over benchmark security. | Investors find it difficult to ascertain the future growth of these instruments due to the benchmark attached to them. |
| The instrument offers a unique diversification with an extra benefit of security. | There is a risk of stagnant returns or lower returns if the market of benchmark security collapses. |
| The instrument offers safety from high market volatility. | The callable floating rate bonds have the risk of being redeemed before proper growth of the investment. |
Know more about: The pros and cons of investing in floating-rate fixed deposits.
So, how do I invest in floating rate bonds?
- Government floating rate bonds
The government offers these bonds with a benchmark of government security. Investors can invest in any floating rate bonds by the government through RBI Retail-Direct. The steps for investment are:
- Register on the above-given website. KYC verification would be done with the registration.
- Further, explore the options of different bonds available for subscription.
- After selecting the desired bonds, payment should be made from the bank account that is linked with the demat account.
- Finally, the investor would receive the purchased bonds in the demat account.
Also, financial institutions like banks offer this facility to simplify the process for investors.
- Corporate floating rate bonds
The floating rate bonds that are offered by the corporates can be easily purchased from the broker or brokerage firms. These days, many applications (brokerage firm apps), such as Zerodha, Upstocks, GoldenPi, etc, offer the facility. All the information regarding the bonds, price, benchmark security, etc, are provided by these firms.
Bottomline
The risk of modern-day volatility and uncertainty could be limited with an instrument like floating rate bonds. The added return spread over the benchmark is a ‘cherry on the cake’ for investors. However, there are certain limitations regarding interest stagnation.
Moreover, there are very few debt instruments with such diversifying characteristics and low risk. Investors looking to generate stable returns over a fixed period such as quarterly or half-yearly, have an excellent opportunity in the form of these bonds.
FAQ
These are debt instruments provided by the government and corporations. However, unlike other debt instruments, they do not offer fixed coupon rates, but their rate is as per the benchmark security. The return spread of some % over and above the return of security accounts for the interest of these bonds. They are usually short-term, and the interest is paid out in certain periods.
Investing in RBI floating rate bonds is a great option as there is less credit risk (default), and the security as a benchmark is a National Savings Certificate. Due to the exposure to government security, there are fewer chances of major volatility. Moreover, the added spread of returns helps safeguard the interest rates of these bonds.
The floating rate bonds mitigate the problem of fluctuations, but there are high chance that the return offered in these instruments is the same for a long period. So, there is a risk of opportunity cost. Moreover, in callable floating rate bonds, the investment may not earn enough return before being redeemed by the issuer.
The main difference between fixed and floating rate bonds is their interests. The fixed-rate bonds assure investors of the coupon rate payment per annum. However, the interest offered by floating rate bonds differs as the security attached as a benchmark with it. Moreover, the fixed rate bonds are vulnerable to market fluctuations, but the floating rate bonds have a cushion of return spread.
The Fixed Deposits (FD) have offered a fixed rate of return with negligible to no risk in the banks. The floating rate bonds offer variable interest rates with low risk. Usually, the comparison is due to periodic returns and less risk. However, the market returns obtained with floating rate bonds are better than FD returns over some time.