The bond market has a wide range of different financial instruments, each of which has its advantages and disadvantages. We’ve already looked at the difference between government and corporate bonds, and now we’re going to delve further into the detail by analyzing the differences between fixed- and variable-rate bonds.

The difference between fixed- and variable-rate bonds

The difference between fixed- and variable-rate bonds is clear. The former pays a fixed coupon rate for the duration of the bond, with the interest paid when the capital is given back at the end of the term. The latter, meanwhile, has coupon rates that alter in value during their lifetime. These variations are linked to various factors, including Ordinary Treasure Bond rates, EURIBOR, the rate of inflation and so on.

It’s quite simple to set out the difference between the two types of bonds, but it’s much more difficult to decide between them. They respond to the macroeconomic events that influence markets in very different – almost opposing – ways.

Bonds are mainly influenced by two factors: interest rates and inflation rates.

Bonds and rates

Fixed-rate bonds, for example, suffer greatly as a result of interest rate increases, because they are unable to maintain market competitiveness. As a result, the price of the bond falls so that its return reflects the new interest rates. Fixed-rate bond investors must, therefore, be adept at predicting interest rate fluctuations – that way, they’ll be able to earn when rates drop and avoid losses when rates increase.

As we said before, variable-rate bonds work in the opposite way. If interest rates fluctuate, the coupon rates of variable-rate bonds adjust accordingly. When rates increase so too to coupon rates – and when rates decrease, coupon rates drop accordingly. This only applies to coupon rates, as the price of the bonds will remain virtually unchanged. 

Bonds and inflation

The relationship between bonds and inflation is very similar to the above. An increase in inflation will lead to a reduction in the price of fixed-rate bonds because coupon rates would no longer cover the investor for the increased purchasing power.

The relationship between variable-rate bonds and inflation depends on the parameters to which performance is linked:

• inflation-linked bonds will see their coupon rates adjust to increases in inflation, resulting in increased earnings for investors (the opposite is true if inflation decreases);
• bonds linked to other parameters may react differently depending on their nature.

These factors and differences must be carefully considered when you’re deciding which bonds to invest in, as the macroeconomic picture will make one type preferable to the other.

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