What are the differences between floating rate and fixed rate in bonds?

Getting started in the world of bond trading requires clear understanding of exactly what is right for the situation the buyer is in, and how they wish to control their money. Thinking about access, the levels of risk exposure and timings are all important in bond purchasing, and help to make a decision in terms of what to invest in.

To fully understand and assess the difference between the types of bonds, it’s important to first establish the notion of interest, known within the world of bonds as a coupon. Like many sectors of the economy the coupon is vital to the levels of return and hence profitability that a bond can bring. Alterations in the interest rate of a country can have a significant impact on the performance of a bond; raises can see returns lessening. Added strain can be placed on the bonds market by a high interest rate in which money is made on savings. Companies and businesses that would have considered issuing bonds to generate needed money may simply be able to use their garnered interest revenue instead to finance new projects.

What are fixed rate bonds?

When obtaining a bond, if it is advertised at fixed rate it means it will have a coupon attached to it that will not alter. It will be specified at the time of purchase, and will not change, no matter what happens to the wider economy or interest rates. The amount of interest attached to it is determined, and will be non-negotiable. The times at which the interest is paid to the bond holder will also be given, and will be at various points before the bond matures and you receive your initial investment back. As fixed rate bonds normally have a long timeframe before they reach maturity, the interest payments are usually relatively small.

What are floating rate bonds?

Floating rate bonds, unlike fixed rate, have a variable coupon that will alter throughout the period until it matures. These floating rate coupons are reset, usually every quarter, to a specified amount over a reference rate, which is most often the three month pound sterling LIBOR interest rate. This is the average interest rate at which banks in London are willing to lend to each other with a maturity of three months. As a result of this, when interest rates rise, so do the coupons.

How do they compare?

Comparing fixed rate and floating rate bonds requires looking at their many advantages and disadvantages and really making a choice based on personal preference and willingness to speculate. With speculation of course comes risk, and while some may be eager to take this on, others may be looking for lower returns in exchange for more security.

Advantages and disadvantages of fixed rate bonds

Perhaps the most obvious advantage in fixed rate bonds comes within the realm of knowledge. When purchasing, the buyer knows exactly what they are getting, and therefore what to expect. From this point of view a sense of peace of mind is provided alongside a feeling of stability, which can be incredibly reassuring to those new to the world of bonds, or those exercising a certain level of conservatism in their attitude to risk. Those that don’t wish to bother themselves with the mechanics of the market and the wider economy may also see advantages. The need to keep an eye on any ups and down and react to them accordingly is removed; holders of fixed rate bonds can simply obtain them and leave them to mature.

As the interest rate is fixed, and is not subject to changes, both positive and negatives are tied into this alone. It is of course great news if interest rates fall, as the bond is protected. The reverse is however also true; should the economy see an interest rate increase, the bond will not benefit.

Fixed rate bonds can work for some, and not others, depending on their plans. For those who are happy to lock their money away for a set period, fixed rate bonds are an attractive proposition. While most do not allow you to withdraw money until maturity, some do, but impose a charge and loss of interest. For those willing or able to guarantee they won’t need access to their money set period, the option is more sound than for those who feel they may need to dip into funds. With this in mind, the longer you are willing or able to lock your money away, the better the fixed rate of interest will be. Consideration of how this interest will be paid can be important. While some fixed rate bonds pay interest monthly, others will pay annually, with the latter inevitably bringing in higher returns.

Advantages and disadvantages of floating rate bonds

Whereas fixed rate bonds are looked to for their stability and reliability, floating rate bonds main benefit comes in the form of flexibility. When the interest rate changes, so does that on your bond, meaning that a rise in interest rates will be reflected in the return you receive, and is positive news. The reverse is of course true should the interest rate fall however. Most floating rate bonds will contain coupons that will pay out on a quarterly basis, with the rate being set at the beginning of these periods, usually calculated by adding the spread to the reference rate. The regular nature of the payments is seen by many as an advantage over fixed rate bonds, which do so less regularly.

With floating rate bonds comes a lack of awareness about how future events may develop; any surprises or shocks in the company will have an impact on the bond, meaning that attempts to plan out what returns may be are often thwarted. In relation to this, it is often necessary for the owners of floating rate bonds to react to the economy accordingly, which can require a certain awareness or willingness to follow developments. Selling and buying bonds at the correct times can form a large part of the activity of serious floating rate bond owners activity; something which may not appeal to those who don’t have the time or inclination to do so.

Making a decision

As is the case with many investment decisions, personal choice is the dictating factor. What works for some may not work for others, and there are considerations that need to be made based entirely on individual circumstances. It is impossible to know how the best returns will be made, and this inability to predict the future of the economy is a large part of the reason many are drawn to the world of bonds in the first instance. Choosing what works from a position of knowledge and exercising careful consideration should ensure that the correct conclusions are reached in the world of bonds.

Provided for informational purposes only. Not designed as advice. Speak to your IFA or tax advisor for advice tailored to your individual circumstances.

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