India followed suit and cut interest rates from March 2020 to May 2020 by 115 bps. The Reserve Bank of India (RBI) has since ensured that rates remain at these historically low levels in order to stimulate lending and economic activity. Even though the world appears to be pushing its way out of the pandemic, the RBI has repeatedly assured that the resumption of growth is still fragile and must be properly nurtured for it to become robust. In addition, he also argued that the current higher inflation is largely due to the disruption of the supply chain and other parameters of a transient nature. However, at its last monetary policy meeting, the RBI provided a schedule for the Reverse Reverse Rate Repo (VRRR) indicating the first step as a departure from accommodative monetary policy. Now, as the economy recovers, the RBI is expected to gradually raise interest rates.
What Happens When Interest Rates Rise?
The price of bonds is inversely related to interest rates. Thus, if the interest rate is reduced, the price of the bond increases and if the interest rate increases, then the price of the bond decreases. The market expects interest rates to start rising as soon as possible and key rates to normalize.
In such a scenario, what should investors do with regard to their bond allocations?
Well, most plans would actively manage term risk to mitigate rising interest rates. However, corpora can also be allocated to variable rate funds.
What are variable rate funds?
By definition, these funds invest at least 65% in variable rate instruments. These bonds have a base rate plus a spread or margin. For example, the base rate is the repo rate and the spread is 200bps. Thus, currently the bonds will have a yield of 4.00% + 2.00% = 6.00%. As pension rates rise or fall, the performance will change accordingly. In the current scenario, if one expects an interest rate hike of 50bp, the yield on said bond would be: 4.50% + 2.00% = 6.50%. Thus, investors in floating rate funds may benefit from higher returns under a rising interest rate scenario.
Main advantages of investing in a variable rate fund
- Diversified fixed income portfolio: In a typical fixed income portfolio or debt fund, the interest rates on the securities are fixed in nature. However, a floating rate fund invests in different types of fixed income securities with varying interest rates, thus diversifying the portfolio and reducing the overall risk of the portfolio.
- Dramatically reduces duration risk: In fixed income jargon, duration risk refers to the risk that the value of your fixed income investment will fall in response to an increase in interest rates, which is usually accentuated when you invest in fixed income securities of longer duration. Floating rate funds present a very low duration risk compared to portfolios that hold fixed income securities of longer duration.
- Offers flexibility: these funds are generally open-ended, which gives you the flexibility to choose when to enter or exit the fund. So if you envision an environment of rising interest rates you can invest in a floating rate fund and if you think the cycle will change you can easily exit the fund.
Floating rate funds aim to maximize flexibility in the management of interest rate risk and improve investor returns through exercise income. Combined with good credit quality and lower net duration risk, these funds can be an ideal solution for fixed income investors looking to improve returns in a scenario of rising interest rates. Among the various floating funds available in the market, one of the funds that has consistently provided superior performance is the ICICI Prudential Floating Interest fund. Over all periods, whether over 1, 3 or 5 years, the fund is among the best performing.
(The author is an AMFI registered mutual fund distributor and owner, Vejani & Company.)