Floating rate bonds, also known as floating-rate notes, are a type of bond that offers investors an interest rate that adjusts periodically based on a benchmark or reference rate. These bonds are becoming increasingly popular among investors due to their potential to provide protection against rising interest rates. In this article, we will discuss everything you need to know about floating-rate bonds from an Indian perspective.
What are Floating Rate Bonds?
Floating rate bonds are debt instruments that are issued by governments, corporations, and other entities. These bonds have a variable interest rate, which means that the interest payments adjust periodically based on a benchmark rate such as the Mumbai Interbank Offered Rate (MIBOR). The benchmark rate is typically set at a fixed spread over the reference rate, such as MIBOR + 0.5%.
How do Floating Rate Bonds work?
A benchmark rate serves as a reference point for the interest rate on a floating-rate bond, causing the interest rate to fluctuate based on changes to the benchmark rate. The benchmark rate is usually set by a central bank or an interbank market, and it serves as a reference point for the interest rates of various financial instruments. The interest rate on a floating-rate bond adjusts periodically based on changes in the benchmark rate.
For example, if the benchmark rate is MIBOR + 0.5%, and MIBOR is currently at 4%, then the interest rate on the floating-rate bond will be 4.5%. If MIBOR rises to 5%, then the interest rate on the floating-rate bond will adjust to 5.5%.
What are the Benefits of Floating Rate Bonds?
Floating-rate bonds offer several benefits to investors, including:
Protection against Rising Interest Rates: Floating-rate bonds provide protection against rising interest rates as the interest rate adjusts periodically based on the benchmark rate.
Potential for Higher Returns: Since the interest rate on a floating-rate bond is tied to a benchmark rate, investors have the potential to earn higher returns when interest rates rise.
Diversification: Floating-rate bonds provide investors with a way to diversify their portfolios by investing in a different type of fixed-income security.
Liquidity: Floating-rate bonds are highly liquid, which means that they can be easily bought and sold in the secondary market.
What are the Risks of Floating Rate Bonds?
Like any investment, floating-rate bonds also come with certain risks, including:
Interest Rate Risk: While floating-rate bonds provide protection against rising interest rates, they are still subject to interest rate risk. If the benchmark rate falls, the interest rate on the bond will also fall, this could result in lower returns for investors.
Credit Risk: While floating-rate bonds are generally issued by highly rated entities, there is still a risk of default. If the issuer of the bond is unable to make the interest payments or repay the principal amount, investors could lose their investment.
Market Risk: Floating-rate bonds are subject to market risk, which means that their value can fluctuate based on changes in market conditions.
Conclusion
Floating-rate notes can be a valuable addition to an investor's portfolio, providing protection against rising interest rates and the potential for higher returns. However, investors should also be aware of the risks associated with these bonds, including interest rate risk, credit risk, and market risk. Before investing in floating-rate bonds, investors should carefully consider their investment goals, risk tolerance, and overall investment strategy.
