Debt Funds: When to Invest in Floating Rate Funds?

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These funds aim to generate returns by creating a portfolio primarily invested in variable rate instruments.

Variable rate funds are debt funds which must invest a minimum of 65% of their portfolio in variable rate instruments. According to data from the Association of Mutual Funds in India (AMFI), floating rate funds are registering strong inflows despite tighter liquidity conditions. These funds recorded a net inflow of around Rs 10,000 crore over the past month and brought the overall management of the net assets of the floating category to Rs 94,751 crore.

These funds aim to generate returns by creating a portfolio primarily invested in floating rate instruments such as debt and money market instruments, including fixed coupon instruments that are converted into floating rates using swaps. Let’s discuss the same in detail.

Main characteristics
A floating rate fund offers diversification to an investor’s fixed income portfolio, as the fund invests in different types of debt securities with variable interest rates, thereby reducing the overall risk of the portfolio. Another advantage of investing in floating rate funds is that it minimizes the duration risk. Duration risk is the risk of loss due to an increase in interest rates in the current market when investors have already invested in fixed income securities of longer duration.

This is often referred to as mark-to-market (MTM) risk. Thus, in situations where the interest rate rises, your investment in floating rate funds presents a lower duration risk than longer term fixed income instruments.

At the same time, the reverse can happen in a scenario of falling interest rates. The open nature of a floating rate fund gives investors more flexibility in terms of entry and exit and the time to stay invested. The expense ratio of these funds ranges from 0.22% to 1.32%.

Linked to the benchmark interest rate
The returns of a variable rate fund are linked to the benchmark interest rate. Thus, in a rising interest rate environment, investing in floating rate funds could generate higher returns than other fixed income funds. However, when interest rates fall, the returns of a floating rate fund may be lower than those of other fixed income funds. Thus, the variable rate fund offers flexibility and self-adjusting functionality to the changing interest rate environment.

Credit risk
In accordance with regulations, 65% of the portfolio is invested in variable rate instruments. The remaining 35% is invested in fixed rate debt securities. It is therefore essential to scrutinize what the remaining 35% of the portfolio holds because sometimes the funds to generate a better return could probably be invested in lower rated bonds, which could expose the whole fund to credit risk.

Who is it suitable for?
Floating rate funds are best suited in a rising interest rate scenario as the interest rate on the underlying bonds would tend to reset to higher levels, thus acting as a hedge against the upside. interest rates which would tend to have a negative impact on fixed rate bonds or bonds on which interest rates are fixed. The fund aims to create a portfolio of optimum credit quality with lower net duration risk, allowing investors to obtain competitive returns compared to investment avenues of similar duration.

To conclude, when it comes to the debt portion of your portfolio, floating funds offer diversification, and in a scenario of rising interest rates and at the same time, these funds present credit risk. So, investors should pay attention to it before investing.

Writing is Professor of Finance and Accounting, IIM Tiruchirappalli

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