On December 6, the Reserve Bank of India announced that the interest rate on the central government's floating rate bond 2031, which will be in effect from December 7, 2022, to June 6, 2023, will be 7.69 percent annually.
"It may be recalled that FRB, 2031 will carry a coupon, which will have a base rate equivalent to the average of the Weighted Average Yield (WAY) of the last 3 auctions (from the rate fixing day i.e. December 7, 2022) of the 182 Day T-Bills, plus a fixed spread of one percent. The Weighted average yields will be computed by reckoning 365 days in a year", RBI said.
In this article, we will discuss about floating-rate bonds, their features and the risks it poses in detail.
What are floating rate bonds?
A floating rate bond is a type of debt instrument with variable coupon payments, indicating that the interest rate changes depending on a benchmark rate that is adjusted periodically. Simply said, a variable rate bond's interest rate changes throughout the course of its tenure. For floating rate bonds in India, the repo rate or reverse repo rate serves as the benchmark.
In India, the government issues the majority of the floating rate bonds, which make up a sizeable portion of the market. The benchmark interest rate for the variable rate bond is 35 points higher than the rate on the current National Savings Certificates (NSC).
These bonds are often issued by governments, financial organizations, and businesses to borrow money from the general public. Depending on the bond terms, interest on these bonds may be paid quarterly, semi-annually, or yearly.
What are the key features of floating rate funds?
A floating rate fund's returns are correlated with the benchmark interest rate. Your investment in floating-rate funds may provide greater returns than other fixed-income funds in an environment with rising interest rates. Your earnings from a floating-rate fund, however, may be less than those from other fixed-income funds when interest rates decline.
Additionally, when you invest in longer-term fixed-income instruments, you run the risk of losing money when interest rates rise in the market. Your investment in a variable rate fund offers reduced duration risk than longer-tenure fixed-income instruments in an environment when interest rates are rising.
Moreover, a floating rate fund offers diversification to your fixed-income portfolio at a low investment limit, in contrast to a standard debt fund where the return is set. It lowers overall portfolio risk by investing in a variety of debt instruments with varying interest rates.
A floating rate bond's open-ended structure might give you flexibility in terms of entrance and exit as well as the length of time you stay invested. It tries to mitigate interest rate risk using flexibility while enabling investors to achieve higher accrual returns.
In order to give investors the opportunity to achieve competitive accrual returns when compared to similar duration investment channels, the bond seeks to build a portfolio with the best possible credit quality and the lowest net duration risk.
Are there any risks associated with floating-rate bonds?
Since floating rate bonds are tied to a benchmark with a short-term rate, the primary risk is that they may end up giving investors a lower yield than fixed-rate bonds. The investor may receive lesser returns from floating rate bonds if the short-term benchmark rate declines.
Furthermore, there is no guarantee that a floating rate bond's interest rate would increase in a rising environment at the same speed as the market rate. Due to the bond’s underperformance compared to market interest rates, the bondholder may incur interest rate risk.
As a result, while purchasing a floating rate bond, there is no assurance of a steady source of income in the future.
If you anticipate a future increase in market interest rates, floating rate bonds are a great way to earn a big amount of money. However, since floating rate bonds also carry some risks, it is always advisable to speak with a financial expert before purchasing a floating rate bond in India.