Governments borrow money from investors through issuing debt securities called bonds. When a government issues bonds, it agrees to pay interest on the money that is owed to the person holding the bond. Usually, payments are semiannual; but, for purposes of this discussion, payments are assumed to be annual (and the government is assumed to be the US government). The annual interest rate is called the coupon rate. Generally, this coupon rate can be structured in two ways: fixed or floating. As the name suggests, when a government bond carries a fixed interest rate, the government has agreed to pay a set annual interest rate for the life of the bond. Therefore, if the interest rate is fixed at 7%, then the government will semiannually pay the bond holder 7% of the remaining debt in addition to the principal payment, which is equal to the original borrowed amount divided by the number of periods. When the government issues bonds with floating inter ...view middle of the document...
There are advantages and disadvantages associated with both types of interest rate structures. We will look at it from an investor's perspective. The fixed rate structure offers two major advantages to investors. The fixed rate bondholder will have a consistent and predictable series of payments. Also, a fixed rate bondholder will benefit when inflation is lower than projected. Using the previous example, the holder would be receiving 7% interest. If the CPI was expected to be 4%, then the investor would be expecting to receive a real interest rate of 3%. If inflation turns out to be 3%, then the investor would receive a real interest rate of 4%, a 1% increase in the real value of that interest payment. The fixed rate structure also has disadvantages. If inflation is higher than expected, then the effects of the previous example would be reversed; and, the investor would receive a lower interest payment in real terms. Therefore, the fixed rate bond investor is not protected from inflation risks like the floating rate bondholder would be. The major advantage to holding floating rate bonds is their protection against inflation. The floating rate bondholder is paid a specific rate in addition to inflation; so, no matter what happens to inflation, the bondholder will receive interest payments of the same value in real terms. For this decrease in risk, the floating rates are usually a little lower than fixed rates. In exchange for no inflation risk, the investor gives up two advantages to having fixed rates. The payment stream is not predictable. Also, there is no potential for the interest payments to increase in real value when inflation is lower than expected. The different characteristics of floating and fixed interest rate structures offer different levels of opportunity and risk to potential investors. These two rate structures offer a choice for investors: 1.) inflation risk with opportunity for increased value in real terms, and 2.) no inflation risk with a concrete, unchanging value in real terms. The two rate structures provide important options for both the government and investor. They act as important tools for governments and investors to achieve their goals.
