Institutional investors and high net worth investors have resorted to floating rates lately. This is evident from the cumulative entries of over Rs 11,000 crore in this category in September and October 2020.
Although the category emerged in 2013, only eight out of 40 AMCs currently offer floating rate funds. Securities and Exchange Board of India, or SEBI, created a separate category for these funds in 2017. SBI Mutual Fund launched its floating rate fund in November 2020.
What are floating funds?
As the name suggests, these funds aim to invest a minimum of 65% in variable rate bonds issued by companies, central and state governments that offer variable interest rates indexed to the interbank supply rate of Mumbai (MIBOR). These funds generally do well when interest rates rise, as floating rate bonds reset their yields based on the prevailing interest rates. But it’s not as simple as it sounds because there aren’t many issuers of floating rate bonds. Thus, these funds employ a derivative strategy to comply with the minimum investment of 65% in floating rate bonds using a combination of fixed rate bonds and interest rate swaps.
Where and how do they invest?
Floating rate funds typically have a term of two years and invest in a combination of sovereign, corporate, money market and interest rate swaps. A large part of the portfolio is invested in AAA rated instruments. In addition, these funds are less volatile than longer duration funds, as evidenced by the low standard deviation of this category. Note that these funds also take credit exposure.
The floating rate bond market in India is less liquid and there are not many issuers of such bonds. Anju Chhajer, Principal Fund Manager, Nippon India Mutual Fund, which manages the Nippon India Floating Rate Fund, explains her strategy in this fund. âThere are two strategies used in this fund. First, we buy fixed rate bonds, when there is no availability of floating bonds, and convert them into floating rate bonds through Overnight Index Swaps or OIS. The combination of fixed bonds and OIS also adds liquidity to the portfolio as both instruments are liquid. A variable rate bond does not mean zero interest rate risk. In the second strategy, we buy floating rate bonds. The OIS curve and the bond curve do not always move in parallel. Bond yields have fallen and the OIS curve has not fallen at the same time. Therefore, we have made money in both segments of the market. We also benefited from a higher carry. These funds aim to make money in a scenario of falling interest rates through the spread. The three-year OIS curve has been in a range over the past 6 months. Since there are not enough floating rate bonds in the market. We have to buy at the right spread.
With interest rates likely to stay low for a while, how are these funds going to behave in the future?
âThe market opinion is that the Reserve Bank of India will remain accommodating for about a year, then a reversal of liquidity measures will occur. This segment of the OIS therefore functioned accordingly. Interest rates will stay low for one year to 15 months. Typically, these funds have a term of approximately two years. If the rates increase, these funds will be less negatively impacted because of the variable rate component and the paid OIS positions, âsays Anju.
How have these funds performed so far?
Over a one-year period, the average return of the Floating Rate Fund category was 8.63%, which is higher than the returns generated by the Medium Term, Money Market, Low Term, money market and ultra-short duration, which are in the range of 3 to 5%.
Should we invest in these funds?
Mumbai-based distributor Rushabh Desai believes retail investors should exercise caution when investing in this category. âFloating funds tend to benefit the most from favorable interest rate movements. Instruments are held to maturity which is closely linked to prevailing interest rates. The average maturity of this category is around 2.5 years. In this context, investors should therefore compare it to the short duration category. Investors can also expect floating funds to be less volatile compared to the short duration category. However, floating funds are not credit risk proof and it will be necessary to examine the funds individually before investing.
While these funds generally benefit from a rising rate scenario, Anju believes that this is an all-season fund, so investors don’t need to time entry and exit. Anju says investors with a two to three year horizon can invest in floating rate funds because floating rate bonds protect investors from interest rate volatility.