Question

I was reading the CFA level I note and saw one of the statements: "Floating-rate bonds are attractive to those who have a variable rate source of funding such as banks. They can avoid the balance sheet effect of interest rate increases that would increase the cost of funds but leave the interest income at a fixed rate."

My question is, what is the balance sheet effect in this scenario, and how they leave the interest income at a fixed rate? Thank you.

Answer 1

Ans : Generally the interest rate on loans from banks are linked to benchmark rates like LIBOR, federal funds rate etc.

As per the government policies and market they tend to change, hence loan interest rate is also get changed with the changes in benchmark. In case if the interest rate seems to increase in near future, it will affect the balance sheet negatively as interest cost will rise with every change.

To counter this effect, floating rate bonds can be a solution , since the coupons of these bonds are also linked to benchmark rates and hence, nullify the effect of interest rate increase in source of funding from banks. So, indirectly we can say that they leave the interest income also fixed as the variable part is being meet out with the increase in loan rates.