Floating Rate funds

This is the only long-term debt fund for investors to consider in a rising interest rate scenario. This is mainly due to the fact that floating rate funds are better geared to take on rising interest rates. Floating rate funds invest in debt instruments that have their coupon rates linked to a reference/benchmark like the MIBOR (Mumbai Interbank Offered Rate) for instance. The MIBOR is a good barometer of the prevailing interest rate scenario in the country. The coupon rate on the debt paper is revised regularly in line with changes in the MIBOR. So at the end of the day, the floating rate debt instrument (and the floating rate debt fund) captures the interest rate mood fairly well, at least a lot more effectively than the fixed rate debt instrument.

Floating rate funds are ideal for investors with an investment tenure of at least 12 months. Again there is little to choose from within floating rate funds since they invest largely in floating rate paper, which is usually rated highly (in terms of credit-worthiness) and carries lower interest rate risk since coupon rate is revised periodically. So the investor has to keep a tab on the expense ratios of these funds while making a selection, because this can make a significant difference to your returns over a 12-month period.

These funds invest mainly in floating rate securities whose coupons are reset periodically , based on a predetermined benchmark. Floating Rates are expected to deliver superior risk adjusted return during the period of volatility and hardening of interest rates.But the times are uncertain, and predicting the movement of interest rates is futile. Interest rates are a function of inflation; if inflation rises, then interest rate should also rise. And with the growth in Indian Economy, inflation could rise in the future.Of course, if crude oil prices come down, inflation will start falling. Rising interest rates hurt fixed income investors. As interest rates rise, bond prices fall and so does the net asset value of a mutual fund.

This is what happened in 2004 when the average debt fund lost 0.9%. To counter a rise in interest rate, the floating rate fund is an attractive option. Floating rate funds invest about 65-100% of their corpus in securities, which pay a floating rate interest, while the rest is in fixed income securities. The price of floating rate bonds also falls when rates go up, but the fall is lower compared to the fall in price of fixed-income bonds.The coupon on floating rate bonds rises periodically as interest rates rise and the investor is protected in terms of interest income. A fixed-interest bond investor loses out as the interest on his bonds is fixed and the price of his bonds also falls. Thus, floating rate funds are a good debt investment option when interest rates are expected to rise. The average floating rate fund has provided 4.66% to investors in the same period. Franklin Templeton Mutual Fund was the first asset management company to launch a floating rate fund in India in February 2002. But as debt Marketsbecame more volatile, more AMCs launched floating rate funds. There are around 40 such funds. When bond yields rise, returns from floating rate funds end up at the top, among all debt... fund categories.

For the three months ended July 29, when the yield on the 10-year benchmark bond went up nearly 100 basis points, income funds’ returns declined 1.7%. But floating funds gained 1.07% in the same period. Even during periods when yields fall, these funds have not done badly with their returns being closer to those of cash funds.These funds have also given enough proof of its consistency. Most of the floating rate securities are linked to Mibor (the benchmark rate). The interest rates on these instruments carry a mark-up of 5 to 90 basis points over the Mibor rate. The Mibor rate is the weighted average of call money business transactions done by 29 institutions, including banks, primary dealers and financial institutions. This rate is calculated and disclosed by FIMMDA-NSE.

The interest rate is reset daily based on the interest rate movements. Floating rate bonds are issued by corporate with sound fundamentals, which means that the credit risk is low. But issuers have preferred short-term floating rate bonds so far, hence both long-term and short-term floating rate funds have similar portfolios.

There is a shortage of sufficient long-term floating rate instruments, which is a problem. The average maturity of both long-term as well as short-term floating rate funds has largely remained below two years, which is low. About a third of the floating rate funds’ portfolio consists of short-term ‘P1+’ rated instruments. Besides, the government has also started issuing floating rate bonds with maturity of 5-16 years, which is likely to give a major impetus to the growth of floating rate bonds. The coupon on the government floating rate bond is reset semi-annually and the benchmark rate for these bonds is the yield on the 364-day treasury bills. While floating rate bonds are good when interest rates are rising, it does not mean that they are immune to interest rate risks.

If the time between resetting interest rate on the floating rate bond is long, these bonds will earn lower interest than what they should. Even if the number of resets per year is lower, the investor will lose out. Yet another risk is that the benchmark interest rate fails to capture the interest rate movement. To sum up, floating rate funds are good investments when interest rates are rising. 

Also, investors should go for a fund that has low expense ratio as returns are not going to be dramatically... different between two floating rate funds.