Advantages of floating rate notes, Financial Management

Advantages of Floating rate notes:

We know that the coupon rate is fixed for fixed rate bonds and that throughout its tenure the investor receives coupons at a predetermined interest rate irrespective of the changes in the interest rates in the market. Further, bonds experience inverse price changes when the market rates of interest change. That is, the price of a bond decreases when there is an increase in the market rates and increases when there is a decrease in the market rates. It has been observed that FRNs will experience only mild price changes between reset dates, the reason being that the reference rate normally moves in tandem with the market rates and the coupon of the FRN is pegged to the reference rate.

It is to be appreciated that FRNs make attractive investment for the investors with a strong need to preserve the principal value of the investment if they desire to withdraw the investment prior to the maturity date of the bond. The reason is very simple; the rate of interest paid as coupon rate is almost the same as the market rate at any given point of time.

FRNs are equally advantageous to the issuers because they need not borrow long-term debt at historically high rates of interest particularly when there is a declining trend in the interest rates. During 1993, MRPL issued partly convertible debentures at 16.5% rate and had to keep on paying interest on the debt portion at the same rate even after five or six years when the market rate of interest had considerably come down. Similarly, the Hyderabad Urban Development Authority (HUDA) also issued bonds at 15% interest whereas the market rate subsequently came down drastically. HUDA is still paying interest at 15% to fulfill its original commitment.

 

Posted Date: 9/10/2012 8:27:56 AM | Location : United States







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