The Mutual Fund Show: How Floating Rate Schemes Can Help As Rate Hike Looms

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Manish Banthia: What has happened over the last few years in fixed income is that we have only seen yields go in one direction. From 2014, when 10-year yields were as high as 9.5% to where it is right now around 7%, yields have only come down.

In the shorter end of the curve – the one-to-two-year yields where investors normally invest in bulk – the FD rates have only seen a downward trajectory. Therefore, it is an interesting time to think about what one should do in terms of investments in fixed income when things have changed.

The last two years have been years of recovery for the economy. When the economy is in recovery, there’s a different sort of investment opportunity which you need to look at in the markets. But when the economy has moved from recovery to expansion, when capacity utilisations are filling up, your inflationary pressures are moving up. Interest rates in these environments tend to move up.

In a rising interest rate scenario, a fixed yield bond normally may not be the right instrument to invest. In a fixed rate instrument bond, if you have a three-year bond, you’re fixing your yield right now. If yields are going to move up, in that journey you are going to lose money.

On the other hand, when yields are going down, if you were investing in a fixed rate bond when yields were moving down, you are actually making more money than the coupon of the bond. So therefore, in a rising interest rate scenario you cannot choose a fixed rate bond because it will come up with a lot of volatility and a lot of pain.

As the interest rate rises, you would like to have better coupons than what you are locking right now. At the same time, you also need to have some capital gains.

Floating rate instruments provide you the solution. These are instruments which are linked to market benchmark rates. It could be either a three-month T-bill, a six-month T-bill, or the Mibor rate which is the overnight rate and they offer a spread over and above that.

As the Reserve Bank of India increases interest rates, the market benchmarks also move and along with a change in market benchmarks, your coupon changes at periodic intervals of time.

For example, the Government of India issues government securities which are linked to six-month T-bill rates, and they are issued in different maturities – five years, 10 years, 11 years. When one chooses to invest in such instruments, if the RBI increases interest rates, the three month and six month T-bill rates will also move up. So, every six months, your coupon is being reset higher.

The beauty of these products is that at present, they are pretty cheap compared to what is being offered by the rest of the market. The spread offered in these products are pretty high. For example, a six-year Government of India floating rate bond is offering a spread of almost 90 to 100 basis points over a six-month T-bill. To start with, you are already getting around 5.5% of income. If the RBI increases interest rates by 100 basis points in the next one year, 5.5% can go to 6.5%.

The overnight index market is already saying that one year ahead, the one-year curve would be at 6.5%. So we are already seeing a sharp increase in the short-term interest rates in the next one year. Therefore, if one invests in these kind of instruments, one not only gets the benefit of higher coupons. Generally, we’ve seen that as the interest rate moves up, the overall coupon on these bonds becomes attractive for investors and the demand from overall investors also increases.

There is also a chance that the attractiveness at which these bonds are priced right now, that attractiveness can compress, effectively meaning that the yields can compress. When they compress, you get additional benefit out of it.

Something which is available at 100 basis points right now, when interest rates start to adjust at 5.5%, the relative attractiveness from an overall yield perspective becomes higher and people will be okay to buy at 80 basis points rather than 100 basis points. You’re not only gaining the coupon part and the spread, but there are also opportunities to get capital appreciation gains in this segment.

Therefore, from all these perspectives, they are opportune instruments in a rising interest rate scenario. The valuations are pretty cheap and from an overall perspective, as compared to all other fixed interest instruments – be it an FD or any other two-year, three-year fixed interest rate bond – these instruments are looking as the most attractive investment points.

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