Introduction

A floating rate bond is a type of bond where the interest rate is periodically adjusted based on a predetermined benchmark. Unlike fixed-income bonds, which pay a constant interest rate throughout their term, floating rate bonds change their interest payouts periodically based on market interest rates.

These bonds are an excellent option for investors looking to benefit from rising interest rates, as the coupon payments increase in tandem with benchmark rates. Floating rate bonds can be issued by governments, corporations, and financial institutions, making them a crucial part of the fixed-income investment landscape.

This article explores floating rate bonds, how they work, their advantages, risks, and how investors can use them to optimize their portfolios.

How Do Floating Rate Bonds Work?

Floating rate bonds do not have a fixed interest rate. Instead, their interest payments fluctuate based on market conditions.

Key Features of Floating Rate Bonds:

• Interest rates reset at regular intervals (quarterly, semi-annually, or annually).
• The new rate is determined by a predetermined formula linked to a benchmark.
• If interest rates rise, the bond pays a higher coupon rate, benefiting investors.
• If interest rates fall, the bond pays a lower coupon rate, reducing investor returns.
• For example, a floating rate bond may pay "Repo Rate + 2%". If the RBI increases the repo rate, the bond’s interest rate also increases.

Benchmarks Used for Floating Rate Bonds in India

The interest rate of a floating rate bond is linked to an external benchmark, which determines the periodic adjustments.

Common benchmarks used in India include:

• RBI Repo Rate – The interest rate at which banks borrow from the Reserve Bank of India (RBI).
• MIBOR (Mumbai Interbank Offered Rate) – The interest rate at which banks lend to each other in the money market.
• 10-Year Government Bond Yield – Used as a reference rate for long-term floating rate securities.
• Treasury Bill Yield – Short-term government securities used as a benchmark.
• For example, if a floating rate bond offers "MIBOR + 1.5%", and MIBOR is 6%, the bondholder will earn 7.5% interest (6% + 1.5%).

Floating Rate Bonds vs. Fixed Rate Bonds

1. Interest Rate Sensitivity

• Floating rate bonds adjust to market interest rate changes, reducing interest rate risk.
• Fixed rate bonds remain constant, meaning investors face losses if interest rates rise.

2. Stability of Returns

• Fixed rate bonds offer predictable, stable income.
• Floating rate bonds offer higher returns when interest rates rise but lower returns when rates fall.

3. Inflation Protection

• Floating rate bonds offer better protection against inflation because interest payments adjust upward.
• Fixed rate bonds lose purchasing power when inflation rises.
• For example, if inflation rises from 5% to 7%, a floating rate bond linked to repo rates increases payouts, whereas a fixed rate bond's value declines.

Types of Floating Rate Bonds

1. Government-Issued Floating Rate Bonds

• Issued by the Government of India (GOI) and considered low-risk.
• Typically linked to repo rates or treasury yields.
• Suitable for conservative investors seeking safe, adjustable returns.

2. Corporate Floating Rate Bonds

• Issued by banks, NBFCs, and large corporations to raise capital.
• Typically linked to MIBOR or corporate bond yields.
• Higher risk than government bonds but offer better yields.

3. Perpetual Floating Rate Bonds

• Have no fixed maturity date and pay interest indefinitely.
• Mostly issued by banks and financial institutions as Additional Tier-1 (AT1) capital bonds.

Advantages of Floating Rate Bonds

1. Higher Returns in Rising Interest Rate Environments

• If RBI increases interest rates, floating rate bonds automatically adjust, leading to higher payouts.
• Fixed rate bondholders, in contrast, earn the same interest despite market changes.

2. Inflation Protection

• Floating rate bonds help investors maintain purchasing power as their interest adjusts with inflation.

3. Lower Interest Rate Risk

• Since rates adjust periodically, floating rate bonds experience less price volatility compared to fixed rate bonds.

4. Good for Portfolio Diversification

• Investors can use floating rate bonds to balance risk and returns, particularly when market rates are unpredictable.
• For example, a balanced portfolio may include 50% fixed rate bonds and 50% floating rate bonds to reduce risk exposure.

Risks of Floating Rate Bonds

1. Lower Returns in Falling Interest Rate Environments

• If RBI reduces repo rates, interest payments on floating rate bonds decrease, reducing investor earnings.

2. Uncertainty in Income

• Unlike fixed rate bonds, floating rate bonds have no guaranteed income stability, making financial planning difficult.

3. Credit and Liquidity Risks

• Corporate floating rate bonds carry default risk if the issuing company faces financial difficulties.
• Some floating rate bonds have low market liquidity, making them harder to sell before maturity.
• For example, during economic slowdowns, companies may struggle to meet bond payments, increasing default risk.

How to Invest in Floating Rate Bonds in India?

1. RBI Retail Direct Platform

• The Government of India issues Floating Rate Bonds (FRBs) that can be bought through the RBI Retail Direct portal.

2. Mutual Funds with Floating Rate Bond Exposure

• Investors can access floating rate bonds indirectly through debt mutual funds that invest in variable-rate securities.

3. Corporate Floating Rate Bonds

• Available via stock exchanges (NSE/BSE) and bond dealers.
• Investors should check credit ratings (AAA, AA) and benchmark linkages before investing.

4. Bond ETFs and Bond Mutual Funds

• Some ETFs focus on floating rate securities, offering investors an easy way to gain exposure.
• For example, HDFC Floating Rate Debt Fund invests primarily in floating rate securities issued by corporations and governments.

When Should Investors Consider Floating Rate Bonds?

• During rising interest rate cycles when RBI increases rates to control inflation.
• When inflation risks are high, as floating rate bonds adjust to inflationary pressures.
• For short-to-medium-term investments, since floating rate bonds minimize interest rate risks compared to fixed rate bonds.
• For example, in 2022, RBI raised the repo rate from 4% to 6.5%, making floating rate bonds attractive due to higher payouts.

Conclusion

Floating rate bonds offer adjustable interest payments, making them an ideal investment for rising interest rate environments. They provide protection against inflation, lower interest rate risk, and potential for higher yields. However, they come with uncertainty in income and credit risks, making them suitable for investors with medium-to-high risk tolerance.

Investors should consider government floating rate bonds, corporate floating rate bonds, and debt mutual funds with floating rate exposure to diversify their portfolios effectively. By understanding market trends and interest rate movements, floating rate bonds can be a valuable addition to a well-balanced investment strategy.

Reference used: https://www.investopedia.com/terms/f/floater.asp

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