The Hindu Business Line : Benefit of a floating rate

Such funds primarily invest in floating rate bonds (or floaters). A floater is one where interest payments are linked to a benchmark rate. A bond that pays, say, one per cent more than SBI's three-year deposit rate is a floater.

If SBI's three-year deposit rate increases from 5.5 to 6 per cent, your bond will earn 7 per cent for the next six months or one year depending on the next reset date.

Suppose you hold a 5-year bond that pays a fixed-rate of 6 per cent per annum for five years. What if interest rate rises after you buy this bond?

Assume that a new 5-year bond will be issued at 6.5 per cent. You will be unable to sell the 6 per cent bond at its face value of Rs 100. Why?

Your bond carries lower interest rate than what the market currently demands. The 6 per cent bond will, therefore, decline in value so that it yields 6.5 per cent. This risk of a bond declining in value due to rise in interest rate is called the interest rate risk.

Now, floaters carry low interest rate risk. Why? Assume that the interest rate increases after you buy a floater. You will receive higher interest rate on your floater from the next reset date. The floater, therefore, pays you market interest rate after sometime.

You do not enjoy this benefit with a fixed-rate bond. So, the decline in value for a floater will be lower than that for a fixed-rate bond if interest rate increases.

With the market now expecting a rise in interest rate, small wonder that there is demand for floating rate bond funds.

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