The Differences Between Fixed and Floating Rate Bonds

When it comes to investing, bonds are a reliable way to earn income and maintain capital stability.

There are fixed rate and floating rate bonds, and each behaves differently depending on the interest rate environment. In order to maximise income payments, or ‘coupons’, over a period of time, it’s important to understand the differences between these two types of bonds.

How bond pricing works for fixed and floating rate issuance

Fixed rate or fixed coupon bonds

Fixed coupon bonds, also known as fixed rate bonds, pay a fixed interest rate to bondholders for the life of the bond. Bondholders will receive a predictable income stream from the bond, making it a popular choice for investors who value stability and certainty.
If you’re looking to gain an understanding of how fixed rate bond prices change, and therefore to get a deeper sense of what types of bond investments may be suitable for your purposes, it’s important to understand the following three terms:

Yield or “yield to maturity”

This metric describes the total income a bondholder will receive expressed as a percentage interest rate assuming they hold the bond until maturity, and therefore receive all interest payments and 100% of the face value of the bond. It differs to running yield which is the annual return/income based on the bond market value.

Fixed coupon

The yearly interest in dollars per $100 invested in a bond that an investor will receive through the life of the bond, and which never changes.

Running yield

This term refers to a bond’s interest rate and is calculated based on the coupon payment and the current market price. This is the annual income from coupon payments that is calculated by dividing the coupon by the current market price and multiplying it by 100. For example, if you have a bond with a 5% coupon that is available at $101.50, then the running yield will be 4.92%.

Fixed coupon bond – Challenger 7.186% 2027 – an example:

Why will a bond price move from its price at issuance?

All bonds are issued at $100 and will mature at $100 or obligated to repay the $100 in full. The bond’s traded price between the issue date and maturity date will be determined by the market. On the day of issue, the bond’s coupon is set as discussed above and at that point, the coupon is the same as the yield to maturity, and the running yield.

As the price of the bond moves away from par ($100), the yield to maturity and running yield will vary. The coupon will never change.
Factors that will affect the yield (and therefore price) of a fixed coupon bond could be (but are not limited to):

• The level of market interest rates set by the RBA, and prevailing rates for Government bonds of various tenors: e.g. lower rates in the economy will generally drive corporate bond prices higher.
• The creditworthiness of the company issuing the bond: e.g. if a company’s credit rating is weakening, investors will demand a higher return to buy that company’s bonds.

Floating rate notes

Floating rate notes, also called variable rate notes, do not have a fixed interest rate. Instead, the interest rate is tied to a benchmark rate, such as the Bank Bill Swap Rate (BBSW),[1] and resets periodically to reflect changes in the benchmark rate. That means the interest rate changes with movements in market interest rates. As a result, the interest payments, or coupons, that bondholders receive can vary over the life of the bond.

Corporations may issue floating rate notes to raise capital and manage interest rate risk. These bonds are popular with investors concerned about rising interest rates as they provide a hedge against inflation. However, floating rate bonds may offer lower initial interest rates compared to fixed rate bonds, and the interest payments can be unpredictable, making them a more volatile investment.

[1] The Bank Bill Swap Rate (BBSW) is the central benchmark interest rate in Australian financial markets at which banks will lend to each other (via bank bills) for periods of six months or less. Administered by the Australian Securities Exchange (ASX).

Example of a floating rate note:

Some factors that affect bond prices

To summarise, interest rates play a crucial role in shaping bond prices and yields.

Fixed rate bonds can provide you with stable and predetermined interest rate payments, and floating rate notes can provide dynamic interest rate payments that adjust with the prevailing market rates.

When interest rates increase, the pricing of fixed rate bonds will fall as their returns become less attractive compared to new, higher-yielding bonds. Whereas floating rate notes pricing doesn’t change when interest rates change.

Other factors that can influence bond prices are credit quality, economic conditions, and issuer-specific risks. The bond issuer’s creditworthiness significantly impacts investor confidence, affecting the bond’s price. Economic conditions, including inflation and economic growth, also play a pivotal role in shaping bond prices and yields.