Investors analyzing fixed-income securities must assess fixed-rate and floating-rate bonds (FRNs) based on their risk-return profile, valuation methods, and attractiveness in different market environments. Below, we explore how to value each type of bond and compare their relative appeal in various interest rate conditions.
1. Valuation of Fixed-Rate Bonds
1.1 Present Value Formula
Fixed-rate bonds pay a predetermined coupon throughout their life, making valuation straightforward using discounted cash flow (DCF) analysis:
1.2 Example: Fixed-Rate Bond Valuation
Bond Details:
- Coupon Rate: 5%
- Maturity: 10 years
- Face Value: $1,000
- Market Yield: 4%
Using the formula:
The bond will be priced above par because its coupon (5%) is higher than the market yield (4%), meaning it’s an attractive investment.
2. Valuation of Floating-Rate Bonds (FRNs)
Floating-rate bonds adjust their coupon payments periodically based on a benchmark rate (e.g., central bank rate, LIBOR, SOFR, EURIBOR).
2.1 Pricing Formula
The price of a floating-rate bond is generally close to its par value because coupon payments adjust to current interest rates:
Since RtR_t resets periodically, floating-rate bonds are less sensitive to interest rate changes than fixed-rate bonds.
2.2 Example: Floating-Rate Bond Valuation
- Benchmark Rate (Central Bank Rate) = 4%
- Spread = 1%
- Coupon Rate for This Period = 4% + 1% = 5%
- Maturity = 5 years
- Face Value = $1,000
Since the coupon rate adjusts every period, the bond price generally stays close to $1,000, unless the credit spread changes significantly.
3. Comparing Fixed-Rate vs. Floating-Rate Bonds
3.1 Interest Rate Sensitivity
| Factor | Fixed-Rate Bonds | Floating-Rate Bonds |
|---|---|---|
| Duration | High (higher price sensitivity to rates) | Low (coupon adjusts, reducing sensitivity) |
| Convexity | High | Low |
| Price Volatility | Higher | Lower |
| Yield Stability | Fixed | Variable |
- When interest rates rise, fixed-rate bond prices fall, while floating-rate bonds adjust their coupons, maintaining their value.
- When rates decline, fixed-rate bonds become more valuable, while floating-rate bonds offer lower returns.
3.2 Yield and Risk Comparison
| Scenario | Preferred Bond Type |
|---|---|
| Rising Interest Rates | Floating-Rate Bond (higher coupons in future) |
| Stable Rates | No clear preference (depends on initial yield) |
| Falling Rates | Fixed-Rate Bond (locked-in higher yield) |
3.3 Credit Risk Considerations
- Floating-rate bonds depend on the issuer’s credit risk and the benchmark rate.
- Fixed-rate bonds lock in a yield, making them safer if the issuer’s credit rating deteriorates.
4. Practical Example: Comparing Two Bonds
Let’s compare two bonds from the same issuer, one fixed and one floating:
| Bond Type | Coupon | Current Yield (YTM) | Duration |
|---|---|---|---|
| Fixed-Rate Bond | 6% | 5.5% | 7 years |
| Floating-Rate Bond | Central Bank Rate + 1% | 5.5% (Current) | 0.5 years |
Which Bond is More Attractive?
- If Central Bank Rates Rise to 7%:
- Fixed-rate bond remains at 6% (lower yield).
- Floating-rate bond adjusts to 8% (7% + 1%), making it more attractive.
- Winner: Floating-Rate Bond.
- If Central Bank Rates Drop to 3%:
- Fixed-rate bond remains 6% (better than market rates).
- Floating-rate bond falls to 4% (3% + 1%).
- Winner: Fixed-Rate Bond.
- If Rates Remain Constant at 5%:
- Fixed-rate bond: 6% coupon (higher yield).
- Floating-rate bond: 6% coupon (5% + 1%).
- Winner: Tie (depends on credit risk and liquidity preference).
5. Key Takeaways
- Fixed-rate bonds are attractive when rates are falling or stable, as they lock in high yields.
- Floating-rate bonds are preferred in a rising interest rate environment, since their yields increase over time.
- Floating-rate bonds have lower duration and are less sensitive to rate changes, making them better for conservative investors.
- Fixed-rate bonds benefit from price appreciation when rates decline, making them ideal for long-term holding in falling-rate cycles.
- Both bond types carry credit risk, but fixed-rate bonds may be riskier if rates increase sharply.
Final Thought
Investors should choose between fixed-rate and floating-rate bonds based on interest rate expectations, risk tolerance, and investment horizon. A well-diversified fixed-income portfolio should include both types to balance risk and return in different market conditions.
