One of the most frequently asked questions I get about fixed income is whether an investor should be buying fixed rate or floating rate bonds. With the Reserve Bank of Australia's (RBA) interest rate cut this week once again bringing this front of mind, I will look at what investors should consider and offer an example of particularly good value available in the market currently.
First, it is worth noting what happens to a fixed rate bond in a falling rate environment. I often use a see-saw analogy to explain how fixed rate bonds work and to show this I will use a very basic example where a $100 bond is issued at a rate of 5%.
If interest rates are then cut to 4%, the price of the fixed rate bond must adjust to reflect this, the original bond has not changed, it still represents the same risk, but the rate of interest investors are prepared to earn (as dictated by the RBA) has changed so holders of the original bond are effectively repriced to reflect the new market reality of 4%. This is just a matter of maths.