Floating rate gimmick

Suresh Krishnamurthy

FLOATING rate bonds the RBI had once restricted the financial institutions from issuing, are now being offered for subscription by ICICI in its latest offer of safety bonds.

The terms of the bonds have been structured in an innovative manner. However, the prime concern behind the innovation seems to be protecting the interests of ICICI. In fact, the bond is effectively not a floating rate bond at all, but is one that offers a put option to investors at the end of two years.

Developments in the sphere of floating rate products have been rapid in the past couple of weeks. The RBI initially came out with an offer of floating rate bonds on behalf of the Government following which banks indicated that they themselves might offer floating rate deposits. Now, ICICI has made this offer.

The interesting aspect is, however, the pricing and the terms of the floating rate bond issued by the Government and the floating rate bond issued by ICICI. The tenure of the bond issued by the Government is five years. In the case of the floating rate bond offered by the Government, the benchmark rate is the 364-day Treasury bill.

The mark-up that has been fixed in an auction is negative .05 per cent. Thus, the interest for the first-half year works out to 7.01 per cent. The prevailing yield on a 5-year government security is 7.10 per cent. Interest rates are lower because the Government has given investors the protection against rising interest rates.

In the case of the floating rate bond issued by ICICI, the maximum interest payable has been capped at 9 per cent. For the first two years, the interest payable is 8.9 per cent. As such, there is no upside potential for you. ICICI, on the other hand, will reap the benefits of any downward trend in interest rates. A comparison with the floating rate bond issued by the Government will make it clear that the coupon rate on ICICI's bond can float only down.

The redeeming feature is the put option given by ICICI at the end of two years. If interest rates have risen beyond 9 per cent, then you can exit and invest in the market. However, if interest rates have declined during the period, you would be caught in a bind. This is because even if you exit you can only invest in the market at a lower rate. If you stay invested, you will receive a lower return linked to the market rates.

In short, the floating rate bond offers you the option of investing the funds in the market two years later. In other words, the interest rate risk is still borne by you. Fortunately, pricing of the bond does not penalise the investors.The coupon of 8.9 per cent offered by ICICI for the first two years appears fair compensation, given the prevailing interest rate situation.

Yes, there is the possibility of an upside. This is linked to the spread over the benchmark. If the spread of corporate securities over the government securities declines to less than 1.5 per cent in the market, then you will gain. However, is it the kind of hedge you are seeking? Overall, the floating rate bond can only be viewed as a marketing gimmick to garner short-term resources.