The expectation of a possible rise in interest rates later this year or early next year is driving many investors and distributors towards floating-rate funds. These funds have got inflows worth over Rs 23,000 crore so far in calendar year (CY) 2021, according to data from AMFI. This is the second-highest inflows for any debt category in CY21.
Floating rate funds invest in debt securities whose coupon rates are dynamic; they either move up or down depending on the interest rate of the security they are pegged to. On paper, that looks to be a good move if we go by the broad consensus on where the interest rates are headed, most likely, in future: up. But floating rate funds do not always work that way. Which is what you must understand before you invest in a floating rate fund.
How does a floating rate fund work?
Floating rate funds have a floating coupon rate, as against a fixed coupon rate that most debt instruments carry. Say, the coupon rate of floating-rate instrument is tagged to 6-month treasury bill. Plus, there is a mark-up of around 0.5 – 1 percent. If the benchmarked treasury bill’s yield goes up, the floating rate instrument pays more. Investors in it, like a mutual fund, get more income. But if the treasury bill’s yield goes down, the investor earns lesser.
Floating rate funds invest in such instruments. Financial advisors say investors with short-term investment horizon can invest in these funds. “The near- to medium-term view is that interest rates are unlikely to fall from current levels, but likelihood of rates rising is more,” says Vikram Dalal, managing director at Synergee Capital Services.
“If inflationary pressures continue to build up both in India and globally, interest rates are likely to rise. The only reason for interest rate to not rise would be if economic growth recovery is weak. Once growth comes back, there won’t be any reason for interest rates to remain so low,” says R Sivakumar, head-fixed income, Axis Mutual Fund.
Floating rate funds have returned 5.5 percent on an average in the past 1-year period. Only categories such as credit risk funds and medium duration funds — which take high credit risks — have given better returns than floater funds in one-year period.
Rise in interest rates don’t always benefit floating rate funds
Joydeep Sen, Corporate Trainer- Debt points out that most of the floating rate funds are pegged to MIBOR; Mumbai Interbank Offered Rate; an interest rate charged by a bank on a short-term loan to another bank. And a small mark-up.
Sen explains that floating rate funds benefit only when the benchmark interest rates rise. MIBOR, which is usually pegged to the Reserve Bank of India’s Repo and Reverse Repo rates, don’t move the way treasury bill and government securities rates do.
“If, for instance, the RBI says tomorrow that it has change its stance from ‘accommodating’ to ‘neutral’, bond and treasury yields will rise. Because such a shift in RBI’s thinking means that it no longer intends to cut interest rates further and more easily. But the MIBOR rate does not change,” he says. This means, that your floating rate funds’ underlying security’s yield does not go up. In simple words, your fund won’t make more money than before. Unless, ofcourse, the MIBOR rate also changes, which will not unless RBI actually changes the rates.
Meanwhile, a rise in bond yields, based on just RBI’s sentiment, would be enough to pull down bond prices. Forget about a hike in your funds’ income, your floating rate fund would actually incur a capital loss.
Only those floating rate funds that use instruments benchmarked to treasury securities benefit by market sentiment movement.
Where are the floaters?
That is not the only problem with floating rate funds. Market experts say that there aren’t many floating rate instruments around. Estimates say that almost 95 percent of debt instruments in the debt market are fixed rate instruments; just about 3-5 percent of instruments come with floating interest rates. How do floating rate funds survive?
Aside from investing in genuine floating rate instruments, they also invest in fixed rate instruments. Then, they convert their fixed interest instruments into floaters, by entering into agreements in the Overnight Indexed Swap (OIS) markets.
Further, “when yields fall, the coupon rate on a floating rate bond gets reset downwards, as it is linked to the market dynamics. On the other hand, the coupon rate on fixed-rate bonds remains intact,” says Dalal. This cannot be ruled out, if economic growth does not pick up.
What should investors do?
Financial advisors say for investors that want to park money for four-six years, investment in a regular bond fund is a better option. “Over longer periods, the price volatility caused by yield movements tends to even out. But, in the near-term if interest rates start to rise, there can be sharp volatility in scheme’s NAV,” says Ashish Chadha, a registered investment advisor.
Sen says that floating rate funds do not have a ”one-to-one” connection with secondary market interest rate movements. These funds take time to react to market movements; as and when the underlying instruments’ coupon rates get adjusted. To which rates are your floating rate funds’ instruments are benchmarked also determine your scheme’s performance. And lastly, how your schemes’ synthetic floaters work also determines your funds’ success. A scheme’s long-term track record and your fund manager’s consistency plays an important role here.
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