BAJAJ BROKING
November 26, 2024
8 mins read
In this article, we will discuss floating rate bonds and their types. We will talk about the risks involved with floating rate bonds and how they work. Further, we will touch upon their pros and cons
Floating rate bonds are the bond types that pay interest on floating rates and tie up to various benchmarks. The floating rates may differ by a fixed-period reset like every quarter. Floating rate bonds are not the same as fixed rate bonds since their interest payment is stable all through the term of the bond. This can make them an appealing investment option in a rising interest rate environment, as their payouts increase with the benchmark rate. In this guide, we’ll explore what floating rate bonds, the types, risks, benefits, and tax implications associated with them.
Floating rate bonds are referred to as variable rate bonds as well. This is the debt security wherein interest payment is reset periodically based on an interest benchmark, and for this reason, floating rate bonds have an interest paying that floats, as in contrast to the fixed-rate bond that gives a set interest to investors. On most occasions, this becomes the sum of the spread or margin set at issue and the benchmark rate.
For example, if the benchmark rate is 3%, then spread 1% means that the interest rate of the bond is going to be 4%.
Most of these bonds are issued by corporations, financial institutions, and governments to hedge increases in interest rates. These types of bonds will work for investors whenever benchmark rates increase compared with fixed-rate bonds in floating environments. Understanding what the floating rate bonds will also facilitate an investor's efforts if she intends to diversify and therefore have a portfolio with which she can ride up if the market interest rates shoot up.
Floating rate bonds, in a nutshell, are bonds whose interest rates periodically adjust to offer a different type of investment for the investor who wants the advantage of rising interest rates but may reduce any interest-rate risk. Now that we know what is floating rate bonds, let’s move onto their types.
Additional Read: What is Trading Account: Definition, Types & Benefits
There are numerous floating rate bonds available in the market, catering to various investors' needs and risk profiles. The primary ones are as follows:
1. Government-Issued Floating Rate Bonds
These are typically low-risk bonds since the government will always back the debt. Ordinarily, these are carrying a fixed rate, though that may be a rate linked to some sort of government benchmark, for instance, the rate of Treasury bills. Such securities have been welcomed by conservative investors since they desire to achieve government backing stability with floating-rate benefits.
2. Company Floating Rate Bonds
This serves as a means for corporate issuers to raise much-needed capital. Compared with governments, corporations have a credit risk associated with the firm's ability to repay debts. The floating rate will be usually a spread of an underlying market benchmark. Hence, corporate floating rate is best suited for investors desiring better yields but which are willing to take up some credit risk.
3. Subordinated Floating Rate Bonds
These are more volatile than plain floating rate bonds as they are subordinate and claim assets to the assets in case of a default of the issuer. Generally, subordinated floating rate bonds carry a yield that will make up for this additional risk. Thus, such a bond can be recommended for those with higher risk capacity seeking more rewards.
Knowing the types of floating rate bonds can help investors know which one is best to use for their financial goal and risk tolerance. Each has different features, and each can provide opportunities to do things differently in investment strategy.
Although floating rate bonds offer protection against a rise in interest rates, they carry with them other risks. The major risks involved in the investment of floating rate bonds are discussed as follows:
1. Credit Risk
Credit risk is the likelihood that the issuer of the bond will fail to make its interest or principal payments. Credit risk is more pronounced for corporate floating rate bonds as compared to government-issued bonds because the creditworthiness of the issuer affects the safety of the bond. Investors may use credit ratings to measure the credit risk attached to a given bond.
2. Interest Rate Cap Risk
Some floating rate bonds have caps on the interest rate to limit how high the rate can go. This would disadvantage investors if rates rise sharply, because the return may be capped and therefore could not maximise from the higher benchmark rate.
3. Liquidity Risk
Not all floating rate bonds have active secondary markets, meaning they can be harder to sell before maturity. This can pose challenges for investors who might need to access their capital before the bond's maturity date. Liquidity risk is especially relevant for lesser-known corporate floating rate bonds. To investors who would want to add floating rate bonds to their portfolio, risks must be fully understood. Even if they provide an edge in some economic conditions, the involved risks must be weighed.
Floating rate bonds work by tying the interest rate of the bond to a reference benchmark, such as LIBOR, the U.S. Treasury bill rate, or the Reserve Bank of India (RBI) repo rate. The interest rate of the bond is typically reset periodically, usually quarterly or semi-annually. This adjusted rate is a combination of the benchmark rate and a fixed spread that was set at the time of issuance of the bond.
For instance, if the floating rate bond is indexed on the LIBOR rate with a spread of 1%, then when the LIBOR rate stands at 2%, the bond will pay interest at 3%. As LIBOR shoots up to 3%, so does the bond's rate at 4%. This feature allows floating rate bonds to change their payoffs in line with changes in market conditions, thus making them effective in an environment of rising interest rates.
The popularity of floating rate bonds in times of uncertainty about future interest rate movements is attributed to the factor that these instruments reduce interest rate risk for investors. Understanding how floating rate bonds work may help investors decide whether these bonds fit into their investment strategy.
Like all other investments, floating rate bonds have pros and cons and knowing the two can guide an investor in determining whether their use can meet the stated financial objectives.
Pros
Conversely, floating rate bonds benefit from the protection of increasing rates since their payments automatically increase with any increase in the relevant rate.
The interest rate risk will be lower. Floating rate bonds are less responsive to changes in interest rates than fixed-rate bonds, and hence they tend to be stable during volatile markets.
Options from various issuers Government, corporate, and financial institutions offer a float rate bond. So, an investor can choose any based on his risk profile.
Cons
Interest Rate Cap Risk: Some floating rate bonds include an interest cap, limiting returns during periods of rising rates.
Credit risk: Corporate floating rate bonds are associated with credit risk as their returns are pegged on the issuer's financial soundness.
Lower Returns in the Low Rate Scenario: Floating- rate bonds in the low -rate world and comparing what that would earn relative to a fixed -rate coupon.
Given the pros and cons, an investor can point out that floating rate bonds would do well in the portfolio under changing market conditions and interest rates.
Additional Read: What is a Bond?
The tax implications here depend on the type of bond, the nature of a specific country's tax regime, and so on. Interest income payable through floating rate bonds are generally subject to income tax; however, there is potential overlap between the tax treatments for government and corporate bonds.
Typically, government floating rate bonds have an exemption state and local taxes, meaning that over corporate bonds, there exists an exemption concerning tax consideration. Corporate floating rate bonds are typically fully taxed. Lastly, capital gains brought about by selling float or floaters before maturity may be subjected to capital gains tax.
A tax advisor should be consulted on tax obligations possibly involved with floating rate bonds. This will make the decision and investment made more tax-efficient based on the tax implications.
1. U.S. Treasury Floating Rate Notes
These are floating-rate bonds that the government issues based on the 13-week Treasury bill rate. These deliver low-risk returns on rising interest rate expectations but do not expose the prospect to the actual credit of a firm.
2. LIBOR-Based Corporate Bonds
Floating rate bonds from many companies pay the interest at a rate on LIBOR. This type of bond has been popular from corporate houses.
3. Repo Rate–Linked Floating Rate Bonds in India
These government-issued floating rate bonds are usually pegged with the repo rate of the Reserve Bank of India. So, floating rate bonds are the best instruments for Indian investors seeking rate-sensitive instruments that have the backing of the government.
4. Municipal Floating Rate Bonds
Some municipalities issue floating rate bonds to finance public projects. The tax-exempt interest makes such bonds attractive to investors in higher tax brackets who would like the benefits of a floating rate.
From the above examples, it is clear that floating rate bonds exist with various levels of floating rates and different terms.
This type of investment in floating rate bonds is somewhat straightforward and can be accessed through the following avenues: there are two main ones.
1. Brokerage Accounts Investors can buy floating rate bonds through brokerage accounts. A brokerage account gives one access to the entire range of corporate and government-issued bonds in the market. This allows for easy trading and management of bond investments.
2. Direct Purchases from the Issuers Some government floating rate bonds, like the U.S. Treasury or the Reserve Bank of India, can purchase directly from the issuing authority. It is an inexpensive route to do so because the purchase usually avoids brokerage charges. Before investing, investors should consider their risk tolerance, financial goals, and the interest rate environment to determine if floating rate bonds are a good fit for their portfolio.
Floating rate bonds are dynamic instruments for investment, and by hedging against the increased interest rates, one would find a good option to invest in. By understanding what floating rate bonds are, how they work, and the risks associated, an investor can make well-informed decisions about incorporating these instruments into their portfolio. With multiple issuers and tax-benefiting aspects, floating rate bonds also present the potential to conservative investors as well as aggressive ones. Again, investors may need to analyse their specific financial objectives and seek recommendations by a financier before investing.
Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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Floating rate bonds are debt securities with interest rates that fluctuate based on a benchmark rate plus a spread. Their interest payments adjust periodically to reflect changes in the benchmark.
Unlike fixed-rate bonds, floating rate bonds offer variable interest payments, making them responsive to interest rate changes and reducing interest rate risk.
Government-issued floating rate bonds may be exempt from state and local taxes. However, corporate floating rate bonds are typically fully taxable.
Yes, government-issued floating rate bonds are considered safe due to government backing. Corporate floating rate bonds carry higher risk, dependent on the issuer’s creditworthiness.
Floating rate bonds can be bought through brokerage accounts or directly from issuers. Consider factors like credit ratings, interest rate environment, and tax implications.
Government floating rate bonds have low default risk, while corporate floating rate bonds carry credit risk depending on the issuer’s financial health.
As interest rates rise, the interest payments on floating rate bonds increase, which can enhance their value. Conversely, in a declining rate environment, their payments may decrease.
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