In addition to fixed-interest bonds, there are some other types of fixed-income securities available on the market, including floating-rate bonds and indexed notes.
Floating-rate notes
A floating-rate bond, also called a floating-rate note, is similar to a fixed-interest bond in that it usually has a fixed maturity date, however the interest rate coupon that is paid for each period fluctuates (or “floats”) relative to a benchmark interest rate. The benchmark interest rate is usually the 90 day bank bill rate, the wholesale rate at which the major banks will lend to the most credit worthy major corporate. The 90 day bank bill rate is also sometimes described as the BBSW (standing for Bank Bill Swap Rate).
When floating rate notes are issued, the interest coupon is fixed as a margin to the benchmark rate (usually the 90 day bank bill rate). While the margin remains fixed throughout the duration of the note, the underlying rate floats, meaning that the interest coupon received every 90 days varies.
At the start of every coupon period, the benchmark rate is determined by the issuer, the fixed margin is added, and the interest rate (or coupon) is calculated for the next payment date in 90 days. For example, if the floating rate note pays a rate of 90 day BBSW plus 2% and the current 90 day BBSW is 4.95%, the next coupon paid in 90 days will be at an effective annual rate of 6.95% pa for that period.
The price of a floating rate note in the secondary market will vary depending on the attractiveness of the fixed margin on the existing note compared with the margin that new borrowers of similar grade notes are now being asked to offer.
For example, if an existing note was issued at a rate of 90 day BBSW plus 2%, and new borrowers of similar credit quality are being asked to offer 90 day BBSW plus 2.5%, then the price in the secondary market for the old note is likely to be less than $100. Of course, the usual supply and demand factors will come into play, as well as any perceived change in the issuer’s capacity to repay the principal when the note matures.
Some floating rate notes may also be ‘tax advantaged’ in that instead of paying interest, they pay a distribution that has imputation credits attached.
Indexed bonds
Another type of fixed-interest security is an indexed bond, which fluctuates in value in line with movements in inflation. The Australian government issues treasury indexed bonds, where the face value of the bond changes each quarter as the consumer price index varies. For example, if the indexed bond commences with a face value of $100 and during the first year inflation is running at 3.5%, the bond’s face value at the end of the first year will be $103.50.
In addition to the face value being indexed, the coupon (which is often paid quarterly) may also be effectively indexed. While the coupon is usually small and at a fixed rate, it is applied to the indexed face value each quarter – meaning that in dollar terms, it increases.
Indexed bonds are generally only issued by governments and usually have very long maturities – up to 25 years. They are attractive to superannuation funds (including SMSFs) because they provide a way to match long term liabilities (retirement benefits) with a long term asset that has a return that is indexed for inflation. Treasury indexed bonds can be purchased from the Reserve Bank (see www.rba.gov.au).
For more on fixed-interest investments, read How to compare bonds.
Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.
