The current interest rate scenario is in a difficult position. While borrowers benefit from the falling cost of capital, this comes at the expense of savers, who are trying to make the most of available rates.
This is when inflation begins to accelerate, which, recognized by the Reserve Bank of India (RBI), remains a lower priority for now. Securing the growth momentum that has been built over the past few months has been the main criterion for central bankers around the world as they try to curb possible defaults. This also encourages savers to take excessive risks to extract this excess return from their capital.
Also, most of the short term options are not attractive in terms of returns and investors cannot take any risk with the medium and long term options as it may prevent them from better future returns.
It is not endemic in India, but all over the world bond investors face the same concern. So how do you take advantage of this situation or how do you generate better risk-adjusted returns in this scenario? Investors might feel reassured by floating rate interest funds.
The Securities and Exchange Board of India (SEBI) has authorized this category of mutual fund (MF) with a minimum investment of 65% in floating rate instruments, the remainder being in other fixed income structures including Overnight Index Swaps (OIS).
As there is a dearth of floating rate instruments in the market, MFs use derivative instruments such as rate swaps or OIS to convert the fixed coupon portfolio into a floating rate portfolio. The reference interest rate is the MIBOR (Mumbai Inter-Bank Offer Rate) or the Repo rate with a quoted spread (premium or discount depending on liquidity).
In a rate change scenario, floating rate funds act dynamically to compensate as much as the change. For example, if one bought an instrument with a coupon of MIBOR + 100 bps (basis points), it is understood that the MIBOR closely follows the operating rate (i.e. repo rate or reverse repo) and in a scenario where there is a change in repo or reverse repo, say an increase of 25 basis points, MIBOR would also rise by 25 basis points.
This ensures that the investor keeps the highest coupon of the variable rate security. This is not the case with a bond or a fixed coupon instrument which is immune to rate changes.
OIS is a hedging contract where two parties swap or swap interest payments on a notional principal. The floating part of the swap is linked to the Overnight Index. The parties understand the two functions of the contract with one representative to pay the fixed rate (OIS rate) and the other agreeing to pay the variable rate.
These contracts have a notional contractual value and cost the parties nothing. Overnight MIBOR rates are compounded daily and at the end of the periodic reset the net interest differential is traded as a net loss position paying off the net gain position.
For example, if the overnight MIBOR is higher than the fixed OIS rate, the party that has agreed to pay the free float will be the net payer of the position and vice versa.
Although I have explained how these funds work, the result is not always in line with our intention and is subject to the vagaries of the market. The composition of the fund is critical for the risk associated with the fund, as the “fixed” part of the portfolio could be diversified and therefore subject to excessive risk if not properly analyzed.
While floating rate funds tend to benefit the most during a period of rising interest rates, offering lower volatility compared to their shorter-term cousins, inherent in this part is credit risk. of the wallet.
The allocation to these funds should be made in the sense of a changing interest rate scenario, as they could decrease returns in a declining interest rate environment.
Likewise, the quality of the instruments must be considered before making an investment and could still be limited to a part of the portfolio depending on the risk profile of the investor.
(The author is co-founder of Wealocity, a wealth management company and can be contacted at [email protected])