All You Need to Know About Floating Rate Funds

Floating Rate Funds

Liquid funds are currently generating around 3.3% annualized return. Interest rates probably MIGHT have bottomed out & may start going up in another 6 months from today (negative for Fixed Income, we will discuss this ahead). Where should you invest in this environment in Fixed Income right now?

(1) While investing in fixed income, we can’t ignore these 3 major risks,

(a) Credit Risk – Something that we saw a little while back with IL&FS, DHFL, Zee etc., where there is a risk to the overall health of the company & hence an increase in probability for a default

(b) Liquidity Risk – Not being able to receive the investment back at the fair market value when you want it. Some products have lock in & hence they don’t allow pre mature withdrawals lets say NSC & some charge you a penalty for the same like say FD’s.

(c) Interest rate risk / duration risk – After you invest, interest rates can go up or down which can be risky.

Lets say you have invested in a bond, which is paying 6% coupon right now & trades on the exchange where the price can move up/down till the maturity. 6 months after you buying the bond, the interest rate in the market goes up. Which means you are still getting paid lower older coupon and hence it’s a negative for the bond you are holding and hence the price of the bond on the exchange falls from 100 to say 95, causing a temporary market-to-market loss. If you hold it till maturity, you still receive 100 back but if you sell today you will only get 95. Which is why rising interest rate scenarios is not favorable for fixed income investing as there can be temporary market to market loss.

Now, Credit Risk & Liquidity, depends on the products you invest in and hence can control but Interest rate risk is cyclical and depends on getting your timing correct. Lets say today’s environment, when yield on the 10 years Gsec is close to 5.88% and in the last 10 years, it has not been any lower than 6% ever. Even if we talk about the last 25 years, only 2 instances when the yields have fallen below 6% which was 2003-4 and 2008-9 down to 5.2% types.

The question here is have yields hit the bottom? I don’t think most people have the answer and nor do it but the probability seems high that the downside in the yield may be limited.

So we have 2 problems at hand, first, yields may have bottomed out and can start moving up which is negative for fixed income (that can be 6 months later also) and if you see returns of liquid funds and similar funds have fallen drastically

Which is why I feel there is a case for looking at floating rate funds right now. Before we understand floating rate funds, lets understand floating rate bonds.

(2) What are Floating rate bonds?

Plain vanilla bonds would generally work like an FD. The coupon / interest rate is fixed and the investor keeps receiving it till they hold the bond.

Floating rate bonds on the other hand are bonds where the interest rates / coupons rate are floating. They are linked to a benchmark like say Repo, Gsec, MIBOR etc. and with the change in the benchmark rate, the coupon rate on the floating rate bond changes.

Latest example is the RBI floating rate bond, which offers 7.15%. The interest of 7.15% is not fixed here, its 0.35% over the NSC rate. So if NSC rate changes to 6.5% from the current 6.8%, the RBI bond will start offering 6.5% + 0.35% = 6.85% instead of 7.15% currently.

(3) Now that we have understood what are floating rate bonds, lets understand what are Floating rate funds?

Floating rate funds are funds, which are expected to invest a minimum of 65% in floating rate bonds. Its difficult to have so many floating rated bonds in the market and hence funds also use interest rate swaps (a derivative) for converting the fixed rated bonds to floating. The derivative part in some other article in the future J

(4) So what’s the case for Floating rate funds today?

(a) Coupons are low and hence the over all returns are low. If you invest today in a normal debt fund except floating rate funds, you will lock yourself in at lower coupons in these funds currently.

(b) If interest rates have bottomed out and lets says if it starts moving up (even 6 months later) its negative for the funds like I have explained earlier.

So if we invest in floating rate funds which will invest in 65% floating rate bonds and interest rates go up tomorrow, the floating rate bonds will adjust their coupons upwards and hence the fund will make more coupons and will not even have the interest rate risk and hence limited mark to mark losses.

In simple words, when interest rates go up, these funds will make more interest.

(5) Who are floating rate funds for?

Investment time required is minimum 1 year in these funds. Also keep in mind that different funds invest in different types of credit papers and hence look at your comfort in terms of credit risk before choosing your fund. A separate thread on credit risk coming soon JWhich is why I feel there is a case for looking at floating rate funds right now. Before we understand floating rate funds, lets understand floating rate bonds.

(2) What are Floating rate bonds?

Plain vanilla bonds would generally work like an FD. The coupon / interest rate is fixed and the investor keeps receiving it till they hold the bond.

Floating rate bonds on the other hand are bonds where the interest rates / coupons rate are floating. They are linked to a benchmark like say Repo, Gsec, MIBOR etc. and with the change in the benchmark rate, the coupon rate on the floating rate bond changes.

Latest example is the RBI floating rate bond, which offers 7.15%. The interest of 7.15% is not fixed here, its 0.35% over the NSC rate. So if NSC rate changes to 6.5% from the current 6.8%, the RBI bond will start offering 6.5% + 0.35% = 6.85% instead of 7.15% currently.

(3) Now that we have understood what are floating rate bonds, lets understand what are Floating rate funds?

Floating rate funds are funds, which are expected to invest a minimum of 65% in floating rate bonds. Its difficult to have so many floating rated bonds in the market and hence funds also use interest rate swaps (a derivative) for converting the fixed rated bonds to floating. The derivative part in some other article in the future J

(4) So what’s the case for Floating rate funds today?

(a) Coupons are low and hence the over all returns are low. If you invest today in a normal debt fund except floating rate funds, you will lock yourself in at lower coupons in these funds currently.

(b) If interest rates have bottomed out and lets says if it starts moving up (even 6 months later) its negative for the funds like I have explained earlier.

So if we invest in floating rate funds which will invest in 65% floating rate bonds and interest rates go up tomorrow, the floating rate bonds will adjust their coupons upwards and hence the fund will make more coupons and will not even have the interest rate risk and hence limited mark to mark losses.

In simple words, when interest rates go up, these funds will make more interest.

(5) Who are floating rate funds for?

Investment time required is minimum 1 year in these funds. Also keep in mind that different funds invest in different types of credit papers and hence look at your comfort in terms of credit risk before choosing your fund. A separate thread on credit risk coming soon J

Source – ValueResearch

(6) RBI floating rate bond vs Floating rate mutual funds?

My choice is floating rate funds specially if you are in the 30% tax bracket

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