Debt funds: When should you invest in floating rate funds?

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October 12, 2021 12:30 AM

Floating rate funds are best in a rising interest rate scenario because the interest rate on underlying bonds would tend to be reset to higher levels

12 Floating Interest Rate-01These funds aim to generate returns by creating a portfolio that is primarily invested in floating rate instruments.

Floating rate funds are debt funds that must invest a minimum of 65% of their portfolio in floating rate instruments. As per the Association of Mutual Funds in India (AMFI) data, floating rate funds see strong inflows despite tighter liquidity conditions. These funds saw a net inflow of around Rs 10,000 crore in the last month and took the overall net asset management of the floater category to Rs 94,751 crore.

These funds aim to generate returns by creating a portfolio that is primarily invested in floating rate instruments such as debt and money market instruments, including fixed coupon instruments that are converted to floating rates by using swaps. Let us discuss the same in detail.

Salient features
A floating rate fund provides diversification to an investor’s fixed-income portfolio because the fund invests in different types of debt instruments with variable interest rates, thereby reducing overall portfolio risk. Another advantage of investing in floating rate funds is that it minimises duration risk. Duration risk is the risk of loss due to an increase in interest rates in the current market when investors have already invested in longer-duration fixed-income securities.

This is often known as the risk of mark-to-market (MTM). So, in situations where the interest rate is rising, your investment in floating rate funds offers lower duration risk as compared to longer-term fixed-income instruments.

At the same time, the reverse can happen in a falling interest rate scenario. The open-ended nature of a floating rate fund provides investors more flexibility in terms of entry and exit and the time of staying invested. The expense ratio on these funds ranges from 0.22% to 1.32%.

Linked to benchmark interest rate
The returns from a floating rate fund are linked to the benchmark interest rate. So, in a rising interest rate environment, investment in floating rate funds could generate higher returns than other fixed-income funds. However, when the interest rates fall, returns from a floating rate fund can be lower than other fixed-income funds. Thus, the floating rate fund provides flexibility and self-adjusting features to the changing interest rate environment.

Credit risk
As per the regulations, 65% of the portfolio is invested in floating rate instruments. The balance of 35% is invested into fixed-rate debt instruments. So, it is essential to scrutinise what the balance 35% of the portfolio holds because sometimes the funds to generate better return could probably be invested in lower-rated bonds, which could expose the entire fund to credit risk.

For whom is it suitable?
Floating rate funds are most suited in a rising interest rate scenario because the interest rate on underlying bonds would tend to be reset to higher levels, thereby acting as a hedge to rising interest rates which would tend to negatively impact fixed-rate bonds or the bonds on which the interest rates are fixed. The fund aims to create a portfolio of optimal credit quality along with lower net duration risk, enabling investors to earn competitive returns as compared to similar duration investment avenues.

To conclude, when it comes to the debt portion of your portfolio, floating funds offer diversification, and in a rising interest rate scenario and at the same time, these funds have credit risk. Thus, investors should pay attention to the same before investing.

The write is a professor of finance & accounting, IIM Tiruchirappalli

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