Bonds are debt instruments that come with fixed-interest rates traditionally. Floating rate bonds are a special type of bond that comes with adjustable or floating interest rates.
For individual investors, these debt instruments resemble much like floating-rate bank loans for you. Floating rate bonds or notes are issued by the same financial entities usually Government financial institutes and large corporations.
Floating rate bond issuers offer a base interest plus usually LIBOR or the FED rate and a margin interest rate. For example, if the Fed rate is 1.25%, the issuer will add a margin or quoted interest rate of 0.25% and the floating rate would become 1.50%.
As the Fed or LIBOR changes with economic conditions and government policies, the total floating interest rate offered on these bonds fluctuates.
Characteristics of Floating Rate Bonds:
Overall Bonds are less risky investments than other stocks. Fixed-rate bonds lose the charm for investors when interest rates rise, as the investors can purchase another bond with higher coupon rates.
Floating-rate bonds eliminate that factor of uncertainty for investors. As the coupon payments adjust with interest rate changes, the investors are less exposed to the opportunity cost.
Floating Rate Bonds offer certain benefits to both investors and issuers against the traditional fixed-rate bonds.
- Investors’ coupon payments adjust with changes in interest rates
- As the floating rate is a combination of the Fed rate or LIBOR, it eliminates the volatility risk for investors
- Floating rate bonds offer the incentive for investors to hold bonds till maturity for higher returns with higher interest rate anticipations
- Issuers can secure investment with floating-rate bonds at a lower than traditional bond rates
- Issuers have the options of limiting the maximum interest rate payments with capping options
Like other debt instruments, Floating rate bonds also offer some risks and limitations to the investors.
- Interest rate fluctuations may yield lower returns if the base rate moves downwards
- Floating rate bonds also face the default risk if issuers face bankruptcy
- Floating rate bonds offer lower Coupon rates than fixed-rate bonds
- If issuers put an upper limit on Interest rates through capping, the investors may still face the opportunity costs with higher interest rate bonds availability
Yield-to-Maturity with Floating Rate Bonds:
Yield-to-Maturity is the interest rate on bonds or financial instruments over the life of the investment. As floating rate bonds adjust with base rates, investors may expect higher total rewards than fixed-income bonds.
Investors with a floating rate bond would tend to keep the investment till maturity by lowering interest rates.
Often, base rates recover in cycles with fluctuating economic conditions. Fixed Income bonds do not offer Long-term interest recovery advantages, as investors look to sell the bonds quickly.
Although the floating interest rate offered is lower, the total yield to maturity with floating rate bonds may be higher.
Interest Rate Effects on Floating Rate Bonds:
The demand-supply rule for the traditional fixed-interest rate bonds with interest rates is an inverse correlation. As the interest rate moves higher, the fixed-interest rate bonds fall in prices and the converse hold too.
Floating rate bonds eliminate that inverse correlation up to a certain extent. However, under considerable economic situations such as the current economic recessions, the interest rate risk may still prevail.
Sometimes, the issuers put a cap and floor options with floating rate bonds. That option helps both issuers and investors to calculate the maximum and minimum coupon payments over the bond lifespan.
In such cases, if interest rates rise significantly above the cap limit, the floating rate bonds will also lose the investors’ appeal.
Important Consideration for Investors:
Investors should make investments with floating rate bonds when the Fed or LIBOR rates are lower. The base rates tend to recover over time as shown by historical data.
Although floating rate bonds mitigate the price and interest rate risks, both risks still exist. Investors looking for long-term capital gains should consider floating-rate bonds as a diversification option.
Regular payments with floating-rate bonds fluctuate over time. Investors can make profits through short-selling on over-the-counter markets as these bonds offer less risk and higher demand.
Regular income with fixed-rate bonds is more certain than floating-rate bonds. Less risk attached to floating rate bonds makes them a popular choice for investors looking to profit with selling quickly.
The Bottom Line:
The Prime differentiation with floating rate bonds the interest rate adjustability feature. Investors can expect higher returns with rising interest rates.
The flexibility of floating interest rates attached to the Fed rate mitigates the price volatility risk.