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Fixed Rate vs Floating Rate Bonds

Fixed Rate vs Floating Rate Bonds

A Bond is a debt financial instrument, with a maturity of over one year, used by the issuer to fund itself in the capital market.

Investors who purchase these bonds are lending funds to the issuer, who undertakes to pay periodic interest/coupons over the life of the bond.

At maturity, the issuer returns the borrowed capital to the investor. The issuers of Bonds are mostly the State, sub-national institutions and public companies – these bonds are classified as public -, and private companies, which issue corporate bonds.

Bonds are also classified as fixed income investments, as they have remuneration rules defined at the time of application and stipulate the term and manner in which the remuneration will be calculated and paid to the investor.

Issuers that show difficulty in honouring their commitments suffer downgrades (deterioration in credit quality) and, if they do not comply with the payments, they go into Default.

The periodic remuneration of a Bond, given by the Coupon Rate, may present different types according to the preferences and expectations of the issuers. The most common types of Coupon are: Variable, Fixed and Mixed or Hybrid.

Variable Coupon Bonds, despite having a fixed spread, have coupons that vary depending on the conditions of the index – which usually changes based on the conditions pre-defined in the terms of the Bond. This indexing factor is represented by an asset or set of assets, which in the case of Mozambique has normally used the Treasury Bill rate (weighted average of the last six issues). The annual inflation rate is also an indexing factor used, but others can be used, such as the valuation of a share, a share index, a fund, an exchange rate, etc.

In international markets, the vast majority of Bonds issued are Fixed Coupon Bonds, as they allow investors to know the Cash Flows they expect to receive until maturity

Fixed Coupon Bonds carry the same Coupon Rate throughout the life of the Bond, regardless of changes in market conditions. Mixed or Hybrid Rate Bonds have both characteristics, with fixed coupons in one period and variable coupons in the other periods.

In international markets, the vast majority of Bonds issued are Fixed Coupon Bonds, as they allow investors to know the cash-flows they expect to receive until maturity, since coupon rates do not change with market dynamics.

The holder of a fixed rate bond can predict exactly what the return on his investment will be, provided the issuer does not default or trigger a call option.

Changes in benchmark interest rates generally affect all interest rates in the economy, but the coupons on these bonds are indifferent to these changes and those of other macroeconomic variables.

The Treasury Department of the Ministry of Economy and Finance of Mozambique issued between 2019 and 2021, mostly Floating Rate Notes, motivated by a scenario of falling main macroeconomic indicators, such as inflation that has reached very low levels historically, key interest rates and exchange rate of the metical.

In 2022, the Treasury changed its preference and began to prioritise the issue of Fixed Rate Bonds, having placed in the Primary Market almost 72% of the total issued in this type of bond by September. The demand/supply ratio of Fixed Coupon Bonds in 2022 has been above 100%, evidencing the preference of investors for these conditions.

The main risk of holding Fixed Rate Bonds is that of interest rates or, more specifically, the risk of similarly risky bond rates increasing as it will cause existing bonds in investors’ portfolios to lose value.

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To give a little example to help you understand: investors buy bonds with a 15% rate of return, but subsequently interest rates in the market rise to 17%. This means that new bonds will be issued at a 17% rate of return, causing the bonds previously purchased at 15% to become worth less – there is an inverse relationship between the price of a bond and interest rates.

If the investor wants to sell his 15% bonds to reinvest the proceeds in the new 17% bonds, he will sell below the initial purchase price because the market value of the bond will have reduced.

The longer the maturity of Fixed Rate Bonds, the greater the interest rate risk they are subject to. In the opposite case of falling interest rates, the result will be the opposite, i.e. if interest rates on bonds of equal risk fall to 13%, bonds paying 15% will appreciate in the market.

In Floating Rate Notes, this relationship does not occur to such an extent, as the coupons adjust for market conditions on the reset date of the months.

An investor should be aware of the dynamics of the market, in order to try to anticipate what the evolution of interest rates will be, as this may dictate the ideal moment to buy a Fixed Rate Bond.

When the expectation is of rising rates, one should favour the investment in Floating Rate Notes, and when the expectation is of falling rates, the best securities to invest in are Fixed Rate Notes.

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