Floating rate savings bond: Is it worth it or should you stick to an FD?

he interest rate of a floating rate bond is linked to a benchmark rate decided at the time of bond issuance. This interest rate is revised quarterly, half-yearly or annually as announced at the time o

The Reserve Bank of India (RBI) last week announced an annual interest rate of 8.05 per cent on the Government of India Floating Rate Bond 2034 (GOI FRB 2034) for the period from October 30, 2023, to April 29, 2024. This is  35 basis points above the National Savings Certificate rate and also a better rate than several fixed deposit options.

Until recently, these bonds were exclusively accessible at select branches of the State Bank of India, nationalised banks, private sector banks authorised by the RBI, and other entities designated by the Reserve Bank of India, following the government's guidelines on floating rate bonds released in June 2020. According to an RBI circular dated October 23, 2023, retail investors can now access a more diverse spectrum of investment instruments through the Retail Direct Portal.

Investors can now subscribe to these bonds using various methods, including cash (up to ₹20,000 only), drafts, cheques, or electronic modes.

What are floating rate bonds? 

FRSBs are interest-bearing bonds issued by the central government. They are non-tradeable and mature after seven years from the date of issue.   Interest on these bonds is paid semi-annually on January 1 and July 1 each year, with no provision for cumulative interest payments.
 

Generally, bonds come with a fixed coupon or interest rate. For example, you can buy a bond of Rs 10,000 with a coupon rate of 5%. In the case of such a bond, you will be paid an annual interest amount of Rs 500 by the bond issuer. This interest is constant and does not fluctuate based on the current interest rate of the market.

However, a floating rate bond is a debt instrument that does not have a fixed coupon rate, but its interest rate fluctuates based on the benchmark the bond is drawn. Benchmarks are market instruments that influence the overall economy. For example, repo rate or reverse repo rate can be set as benchmarks for a floating rate bond.

The benchmark rate used to determine the coupon can vary, including the repo rate, reverse repo rate, average T-Bill rate, and savings scheme interest rate.

The interest rate on RBI Floating Rate Bonds is linked to the prevailing market interest rates, specifically, the National Saving Certificate (NSC) rates, with a spread of 35 basis points. The current interest rate on the RBI Floating Rate Bonds is 8.05%, subject to revisions every six months. The interest received on these bonds is taxable at a slab rate, similar to any bank FD. 

Investors buy floating-rate bonds because of their flexibility to reflect the current interest rate of the market. If the interest rate of the benchmark rises, the interest rate payable for the floating rate bond rises too. 

Such bonds make sense in a rising rate environment.  RBI is expected to keep the repo rate unchanged for at least the next year. 

The interest rate on these bonds is reset every six months and is due on January 1, 2024, next.  Compared to fixed deposits, the interest rate on these floating-rate bonds is higher but the bond rates could be revised downwards in the next review cycle if inflation remains under control. 

" Such bonds are suitable for conservative investors seeking assured returns from a lump-sum investment. Not suitable for investors who can assume some risk by investing in equity-linked investments, which can generate much higher returns. Alternatives can be (i) Balanced mutual funds (for those who can assume risk), (ii) Bank fixed deposits, though the rate of return is lower, and (iii) Company deposits," said Value Research in anote. 

Your capital in floating-rate bonds is fully protected. However, there is no inflation protection, which means whenever inflation is above the latest interest rate, the deposit earns no real returns. However, when the inflation is below the current interest rate, it does manage a positive real rate of return.

Moreover, these bonds are not listed and traded and you cannot take loans against them. "You are effectively locked in for a tenure of seven years. However, pre-mature encashment is allowed with a penalty for senior citizens after a minimum lock-in period, which varies from four to six years depending on the age bracket in which the senior citizen falls," noted Value Research. 

You can only exit from floating-rate bonds after their maturity at the end of seven years. The interest on these bonds is fully taxable. There is no deduction on the principal investment.

Pros and Cons as per BankBazaar 
 The pros are that this is a sovereign bond so you get 100% assured returns and capital safety. There’s liquidity twice a year through interest payouts. And if you’re in a low-interest environment, this instrument assures automatically higher returns as and when rates go up. Essentially, it’s like a floating rate fixed deposit which some large banks offer. The cons are that it’s not a liquid instrument due to a seven-year lock-in, though senior citizens can liquidate the bond in 4-6 years. It’s not tradeable as well like many bonds are. Secondly, we’re in a high-rate scenario where rates are not likely to rise too much and are poised to fall. Also, the returns are fully taxable.

What should investors do?

"If you’re an investor under 60, you may get similar returns from a regular bank FD though only smaller banks will currently go over 8%. But even if you’re offered 7.5%, you can lock into that for 5-10 years. If you’re above 60, you can avail the Senior Citizens Savings Scheme offering a floating rate of 8.2% over 5 years, with the option of extending the investment in blocks of 3 years. If you’re the parent of a girl child, you can earn tax-free returns of 8% from Sukanya Samriddhi but it’s a much longer investment," said Adhil Shetty, CEO of Bankbazaar.

For those seeking a guaranteed fixed interest rate, FDs are the safer option, while RBI floating rate bonds are suitable if you anticipate interest rates rising in the future.

"For investors under 60, regular bank fixed deposits may offer similar returns and even smaller banks currently offer rates above 8%. Senior citizens can consider the Senior Citizens Savings Scheme, which provides an 8.2% floating rate over five years. For long-term financial goals, the compounding of returns is essential, which FRSBs do not offer," said Abhishek Jain, Head of Research, Arihant Capital.

"As this is a floating rate bond, this decision must be based, not on the 8.05% coupon from July 1- December 31, but on how coupons are likely to move in future. .. Moreover,  given that the FRSBs have a 7-year tenure for which you are locked in, rates are bound to fall during your holding period for the bond. FRSBs may not be the first option for senior citizens seeking regular income today, as we may be close to the peak of this rate cycle," said financial product consultant Aarati Krishnan in a post on Prime Investor.