Bond Rates in Corporate Finance
In the world of corporate finance, you need to consider fixed-rate bonds and floating-rate bonds. Fixed-rate bonds are pretty simple. If the bond says it pays 1 percent interest plus principal, then that’s exactly what you’re going to earn. There are no changes, no fluctuations, no nothing.
The nominal cash flows of a fixed-rate bond are exactly as advertised: repayment of the principal with added interest payment equal to the percentage rate.
A floating-rate bond, on the other hand, is one where either the interest rate or the principal payments are variable. So, the amount of money you make on investing in floating-rate bonds changes over the life of the bond.
You may make 1 percent one year, 100 percent the next year, and then 2 percent the year after that, depending on what the bond is pegged to. That’s how the returns on these bonds is determined: They’re tied to some other measure.
Treasury Inflation-Protected Securities (TIPS) are one form of floating-rate bond. TIPS increase or decrease at the same rate as the CPI. Similarly, other floating-rate bonds change in value with a number of other potential measures. Here are a few more common types of floating-rate bonds:
Interest Rate Float: The simple interest rate float is easily the most common form of floating-rate bond. The interest rate on these bonds floats with the market interest rate. If the interest rate offered on bonds for sale on the open market increases, the bond pays more, matching the market interest rate. On the other hand, if the market rate decreases, so do the returns on your floating-rate bond.
These bonds are good options for attracting investors speculating on interest rate increases, while benefiting issuing corporations when market interest rates decrease.
Inverse Interest Rate Float: Inverse interest rate floats are bonds that offer returns that are the opposite of the market interest rate. They work just like standard interest rate bonds, except they go in the opposite direction. When the market rate goes down, the rate on these bonds goes up, and vice versa.
Investors like these bonds when interest rates are projected to decrease, and issuing corporations like them when interest rates are projected to go up. These bonds are also helpful for portfolio risk management, because they allow bond investors to buy equal amounts of opposite-direction floating-rate bonds (interest floats and inverse interest floats) to protect against all interest rate changes and help stabilize interest rate returns.
Many investors feel this minimizes returns, though, because a strategy of using your money to buy only the best investments, instead of using a portion for risk management, decreases potential.
Indexed Bonds: Indexed bonds are floating-rate bonds whose interest rate is pegged to any of many available indexes. For example, if you buy or sell a bond pegged to the NASDAQ stock index and the NASDAQ increases by 10 percent, your interest rate will also increase by 10 percent.
Be careful in the way you interpret these increases. If your NASDAQ-pegged bond starts out paying 1 percent and the NASDAQ increases by 10 percent, your bond won’t increase to 11 percent returns; it will increase to 1.1 percent returns. A 10 percent increase on 1 percent is an additional 0.1 percent.