Last Updated on Feb 28, 2020 by James W
When bonds are issued with a specific fixed rate bonds for long term saving, they are called fixed rate bonds. In other words, the rate of interest on bonds with a fixed rate never changes. This is different from floating rate bonds where the rate of interest fluctuates continuously based on the average rate of interest which can change on a daily basis.
Since the average rate of interest can vary wildly, many investors, especially more conservative investors, prefer to buy fixed rate bonds since the rate of return can be predicted precisely. This allows them to plan their financial re-investments more precisely. It also allows for longer term planning without having to wait and see what the rate of return will be on floating rate bonds.
Investing in bonds with a fixed rate can also give an investor more peace of mind over investing in bonds with a floating rate. This is because the investor does not have to worry about sudden down shifts in the economy or dramatic news events that can suddenly affect the average rate of interest.
When municipalities, and others, issue bonds, they usually prefer to issue fixed rate bonds because they can calculate in advance how much will have to be paid out to those who invest over the lifetime of the bonds. With floating rate bonds, they’d really have no idea of how much would have to be paid out and it would be too difficult to plan for this since unexpected events could drastically change anything that might be predicted.
In other words, bonds with a fixed rate are not only a safer investment for the investors but also for those entities that issue them. So, for example, if a city is trying to raise money for fixing roads, updating the water purification system, building a new library, or another city project, it would be much safer for them to issue bonds at a fixed rate to those who want to invest. In this way, they can predetermine exactly how many bonds they need to issue to fund the project in question.
Fixed rate bonds have the disadvantage of not being able to increase their return on investment any more than the fixed rate. This is the reason that some investors prefer to invest in floating rate bonds. This is particularly true if they are good at financial research and have reason to believe the average rate of interest will increase in the near future and will stay at a higher rate for most of the duration of the bond they have bought. Even though they present more risk than bonds with a fixed rate, there is also an opportunity to make a much higher rate of return.
Whether an investor decides to invest in fixed rate or floating rate bonds depends very much on the personality or the investor. It is also dependent on the financial position and goals of the investor at the time they buy the bond(s). Fixed rate bonds represent a very safe sure bet which floating rate bonds have more risk but may also pay off bigger.
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