A checklist before you invest in a Floating Rate Fund

By Morningstar |  06-08-21 | 

Floating rate funds are debt funds that must invest a minimum 65% of their portfolio in floating rate instruments.

One of the well-known instruments are Floating Rate Bonds. But given limited issuances of floating rate instruments in the domestic debt market, mutual funds use derivative instruments such as interest rate swaps to convert fixed coupon instruments to floating rate by using Interest Rate Swaps like Overnight Index Swap.

What is a Floating Rate Bond, or FRB?

In the case of a regular bond, the coupon rate is fixed for its entire tenure. Not so in this case.

As is evident from the term floating, the interest rate is variable and pegged to an external benchmark. The latter could be the Mumbai Interbank Offer Rate (MIBOR), the Reserve Bank of India’s (RBI’s) repo rate or the 3-month treasury bill yield. Accordingly, the interest rate of the bonds moves up or down.

Let’s take an example - RBI's Floating Rate Savings Bonds 2020 issued by the Government of India. These bonds were available for subscription on July 1, 2020, and the interest rate was linked to the National Savings Certificate (NSC); benchmarked at 0.35% above the prevailing NSC rate. The interest rate, initially fixed at 7.15%, would be reviewed every six months. The rate remained unchanged from January 1 to June 30, 2021, and from July 1, 2021 to December 31, 2021.

What are interest rate swaps?

An Overnight Index Swap (OIS) is used to hedge interest rate risks. An OIS is an interest rate swap agreement where a fixed rate is swapped against a pre-determined published index of a daily overnight reference rate like MIBOR.

In an OIS, two parties agree to exchange the difference in the accrued interest arrived according to the fixed and floating interest rates at the maturity on the notional principal amount.

Interest rate swaps convert fixed rate bonds into floating rate ones. The fund agrees to pay the bank a fixed rate in exchange for a floating rate linked to a benchmark. The bank might agree to pay MIBOR + 3% in exchange for fixed interest rate payments from the fund’s bonds.

Why are investors currently investing in these funds?

  • Interest rates

While interest rates are currently low in India, it is unlikely they will dip further, but could witness a gradual increase going forward. This is the reason many investors are considering these funds.

These funds are very sensitive to interest rate movements, but not like a typical fixed income fund. When interest rates are poised to rise, these funds can be attractive.

Debt investments move inversely with interest rates (i.e. as rates rise, prices fall and vice-versa) since the value of the future fixed cash flows declines in present value terms. However, the cash flow in case of floating rate instruments is linked to a reference rate which is reset periodically and hence aligns more closely to market interest rates. As a result, these funds gain since during rising rate cycle the interest earned keeps resetting higher.

Please read What is yield to understand that better.

  • Diversification

When it comes to the debt portion of your portfolio, such funds do offer diversification given they react differently to interest rate changes than typical debt instruments. In a rising interest rate scenario, such funds can give a higher return than regular debt funds which are likely to get marked down given their inverse relationship with interest rates. Do note, the reverse can happen in a falling interest rate scenario.

  • Duration risk

This refers to the risk of Mark to Market (MTM) loss due to increase in interest rates in the market when you have invested in longer duration fixed-income securities. In a rising interest rate scenario, your investment in a floating rate funds offer lower duration risk as compared to longer tenure fixed-income securities.

Kaustubh Belapurkar, director of fund research at Morningstar India, sums it up well: “While short-duration funds must still form the core of an investors’ debt portfolio, floating rate funds can be added in a lower yield environment when the expectation is that interest rates will start inching upwards. On the other hand, funds with duration exposure would be relatively better options in a scenario when interest rates are headed downwards.”

4 things an investor must consider before investing:

  • Return: Current 1-year return is in the range of 2% to 8%.
  • Expense ratio: Varies from 0.22% to 1.32%.
  • Tax: Floating rate funds are debt funds and taxed accordingly. If you sell your units within three years of investing, the gains are taxable per your personal tax bracket (short-term capital gain tax). If you redeem after three years of investing, the gains are taxed at 20% with indexation (long-term capital gain tax).
  • Credit risk: The mandate is that 65% of the portfolio should be invested in floating rate instruments. The balance portion in debt instruments is invested into fixed-rate instruments. Hence, it is necessary to check what the balance 35% of the portfolio holds, as in the hunt for yield, they could invest in lower  quality paper which could expose the portfolio to credit risk.
  • Interest rates: Floating rate funds are suited for a rising interest rate scenario since the coupon / interest rate on underlying bonds would tend to be reset to higher levels. Thereby, acting as hedge to rising interest rates which would tend to negatively impact fixed rate bonds or the bonds on which the interest rates / coupons are fixed.

So how must investors consider these funds? Portfolio specialist Dhaval Kapadia, who heads the Morningstar Investment Management team in India, tells investors what to keep in mind,

Currently, yields on floating rate funds are marginally lower than those available in other short term debt fund categories such as corporate bond funds, banking & PSU funds and short duration funds, with similar expense ratios. And it doesn’t appear that the RBI is in a hurry to hike interest rates given concerns around the third wave and fragile economic recovery.

Accordingly, one can consider other short-term debt categories mentioned above with at best a small allocation to floating rate funds.

Probably when there are clearer indications of upcoming interest rate hikes one could shift a portion of their allocation to floating rate funds.

The interest rate cycle is key for floating rate funds as they would tend to deliver lower returns in a falling interest rate cycle and vice-versa.

Given the nature of floating rate funds, interest rate risk would tend to be minimal, accordingly one can consider tenures of 6 to 12 months as well.

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