Floating rate bond

An ordinary bond fixes its interest rate on the day it is issued and keeps it until maturity. If market rates rise the next year, the investor is stuck with the old rate; if they fall, the issuer is stuck paying it.

A floating rate bond removes that bet. Instead of a fixed number, the bond document states a method: take a named benchmark, add a fixed mark-up, and reset the coupon on a schedule. When the benchmark moves, the coupon follows at the next reset.

So the investor knows the formula in advance but not the rupees. The workbook makes the point in Chapter 1: for floating rate bonds and inflation indexed bonds, it is the method by which the rate will be determined that is described upfront, not the rate itself.

The workbook's example is the one to learn. A company issues a 5-year floating rate bond, with the rate reset semi-annually with reference to the 1-year yield on central government securities plus a 50 basis point mark-up. The coupon is reset every six months based on that 1-year benchmark.

Three pieces define every floater:

Other names. Floating rate bonds are also called variable rate bonds and adjustable rate bonds — terms generally used where the coupon is reset at longer intervals of a year and above. The workbook notes these are common in the housing loan market.

A special case. An inflation indexed bond is a floating rate bond whose benchmark is the inflation rate; such instruments are generally government securities issued by the RBI and give inflation-protected returns.

Against the plain vanilla bond. A fixed rate (plain vanilla) bond pays pre-defined interest at specified intervals and returns principal at maturity. Chapter 3 teaches that bond prices move inversely to interest rates; a floater's periodic reset is what brings its coupon back in line with the market at each reset date.

For the registrar, a floater changes the interest run: the per-bond amount has to be recomputed at every reset before entitlements are calculated from the record-date beneficial owner position.

Coupon rate for the period = Benchmark rate on reset date + Mark-up
Interest per bond          = Face value × Coupon rate × (months in period ÷ 12)

Illustrative figures, using the workbook's structure. An NBFC issues floating rate bonds of Rs 1,000 face value, coupon = 1-year G-sec yield + 50 bp, reset and paid semi-annually.

An investor holding 5,000 bonds receives:

First half-year  = 5,000 × Rs 36.50 = Rs 1,82,500
Second half-year = 5,000 × Rs 38.75 = Rs 1,93,750
Third half-year  = 5,000 × Rs 35.50 = Rs 1,77,500

The 50 bp mark-up never changed. Only the benchmark did.

Compare a fixed 7.30 percent bond bought on the same day. When the benchmark rose to 7.25 percent, its holder still received Rs 36.50 per half-year — and a new buyer would pay less than face value for it, because new bonds were paying more. The floater's holder simply got a higher coupon at the next reset.

Chapter 3.4(iv) (Floating Rate Bonds) carries the definition and the semi-annual reset example; 3.4(v) makes inflation indexed bonds a category of floater; Chapter 1.1 mentions both under cost of capital. Expect an identification question on the benchmark-plus-mark-up structure and a direct one on the alternative names.

• The coupon is reset at intervals, not changed continuously. In the workbook's example it is fixed for six months at a time.
• The mark-up stays constant; only the benchmark moves.
• 'Variable rate' and 'adjustable rate' are the names generally used when resets are a year or longer apart — they are not different instruments.
• An inflation indexed bond is a floater, with inflation as the benchmark, not a separate family of fixed-rate bonds.
• Floating is not zero coupon. A zero coupon bond pays no periodic interest at all; a floater pays interest every period at a changing rate.
• The coupon is still applied to face value, never to the market price.