Floating rates: Augurs well for investors

Suresh Krishnamurthy

INDICATIONS that banks may come out with floating rate products is a good development for retail investors.

Essentially, the returns on a floating rate product would vary depending on the trend in interest rates. If interest rates fall, returns will decline and if interest rates rise, then returns would increase.

The news about introduction of floating rate products augurs well for investors now mainly because of prevailing level of interest rates. The bank rate, which is an indicator of trend in interest rates, is now at a level that it had not touched at any time after 1973. At the same time, investors do not have any mechanism for protecting themselves against interest rate risk. Products do not offer variable rates and they do not offer a put option to investors either. In this backdrop, introduction of variable rate products will be a welcome development.

However, investors would be right if they receive the news with scepticism. The majority of the assets of banks represented by advances to borrowers are linked to a floating rate, which is the prime lending rate. As such, they will not have to significantly worry about the impact of interest rates on their financial performance. This is because their incomes will rise along with their expenses. In short, they will at least have a partial hedge.

However, banks are unlikely to be enthusiastic about introducing these products because interest rates are at a particularly low level. In fact, without sufficient prodding from the regulatory authorities. Banks are likely to take a long time before they introduce such a product. Another reason that might force banks to offer variable rate products is if small savings schemes move to such a structure. Either way, it is too soon to think that such products will hit the market at a short notice.

Investors also need to consider another factor. The benchmark to which the coupon rate will be linked will be a crucial factor that would determine the efficiency of the instrument. Banks are said to be offering this product because the Government announced on November 15 the introduction of floating rate bond with a term to maturity of five years. The benchmark for that product is the average yield on 364-day treasury bills for a specified period. Banks will also obtain a mark up over the benchmark rate.

It remains to be seen if banks will also link their own product to the same benchmark, or link it to a different benchmark. If they do then the difference in the mark up over what the banks receive from the government and what the banks are willing to offer is large then the attractiveness of the instrument, will be reduced considerably.

Interestingly, the committee set up to review the system of administered rates has said that both inflation and the bank rate cannot be good benchmarks. Though they said this in the context of the small savings schemes, it will apply equally to term deposits of banks.

In this backdrop, in all likelihood, the yields on government securities - by far the most liquid fixed income security in Indian debt markets - will be the benchmark. However, the particular government security and the mark up over the security will decide the attractiveness of the instrument.