Fixed rate bonds are bonds that are issued with a specific rate of interest that applies for the life of the bond. This is in contrast to a floating rate bond, where the interest rate fluctuates based on the current average interest rate. The rate of interest, known as a coupon rate, may be paid at specific intervals during the life of the bond, or be provided in a lump sum when the bond reaches full maturity.
For some investors, fixed rate bonds are decidedly better options than going with floating rate notes. More conservative investors who want to know exactly what the rate of return will be on the investment often prefer the fixed rate coupon, since it is easier to plan what to do with the return when it is received. Going with the fixed rate also means that the investor does not have to be concerned about sudden or drastic shifts in the economy that could have an adverse effect on interest rates, and thus minimize the projected return on a floating rate bond.
Some issuers also prefer fixed rate bonds, simply because it is easier to calculate how much will be paid out in interest to investors over the life of the bond. This benefit can be especially important for municipalities that issue bonds as a means of financing improvements to municipal property, such as paving streets or renovating buildings owned by the city or town. Since taxes are often the source of income used to pay back the amount of the bonds plus the applicable interest, the fixed rate helps planners to determine the amount of additional taxation that is necessary to adequately fund the project.
Other investors find that fixed rate bonds are not to their liking, simply because there is no opportunity to increase the return on the bond issue. For this reason, some of these investors are willing to take on the additional risk associated with a floating rate, especially if their research indicates that the average rate of interest is likely to increase and remain at an elevated level for the majority of the bond’s life. While there is always the possibility that the projections will not prove accurate, the possibility of making more of a return is appealing enough to take a chance on earning that higher return.
The decision to invest in fixed rate bonds is a personal one. While the fixed rate approach is more of a sure thing for the investor, the floating rate offers the potential for greater return. Investors should look closely at market indicators and project whether the rate of interest is likely to increase over the life of the loan, and remain at higher levels long enough for the return to be greater than going with the fixed rate. Once that projection is in hand, it is much easier to determine which type of bond rate is likely to be in the best interests of the investor.