Interest rates in the economy seem to have bottomed out and are currently hovering near their all-time lows. The interest rate-cutting cycle that the central bank resorted to over the years to prop up the economy seems to be over. On the other hand, the fiscal deficit – the gap between the expenditure and income of the central Government –is expected to go up in the years ahead, thanks to the Covid impact. This in turn is expected to keep inflation as well the interest rate in the economy on the higher side. 

Is there a way to benefit from these rising interest rates?

Mutual funds tout floating-rate bond funds as the answer. 

What exactly is a floating-rate bond fund?

Floating-rate bond funds are mutual fund schemes that invest predominantly (65% or more) in bonds that have a floating coupon rate. It typically invests in bonds whose coupon rates are linked to that of market interest rates. To understand it better, you can draw its parallel with a floating-rate home loan. Whenever the repo rates rise, you pay a higher interest rate (and EMI) and vice versa. Similarly, you benefit or lose out from any changes in coupon rates of floating-rate bonds. 

How does it work?

In a regular bond fund, NAV falls whenever there is a rise in interest rates. That’s because of the inverse relationship between interest rates and bond prices. After all, the prices of bonds have to fall to reflect the new bond yield which is higher now. Also, the more the tenure of the bond holding, the greater is the price/NAV correction, as it has to adjust for the lower coupon of that many years. 

In contrast, floating-rate bond funds technically invest predominantly in bonds whose coupon rates are floating and in sync with market rates. So, whenever, there is a hike in interest rates, only its coupon rates increase and you witness a NAV appreciation from the improved earnings (without a correction in the bond prices). 

Limited supply

While all seems hunky-dory, investors need to exercise caution. For one, there are not enough floating rate bond papers available in the market. So, fund managers exercise a derivative measure of swapping, whereby the cashflows of fixed-rate bonds are swapped for that of floating-rate bonds with the counterparty. It is fraught with ‘basis risk’ –the risk of bond prices not moving in tandem with the market rates. 

Secondly, there are liquidity-related issues. It might not be easier to get out of these bond papers or only exit at a certain price. 

Thirdly, these funds are not devoid of credit risk. Most of the time, these funds invest in corporate bonds in addition to government bonds. And some mutual fund schemes take more credit risk (to improve yields) by investing outside the top-quality (AAA-rated) bonds than others. Any deterioration in the company’s financials can lead to default or delay in payments which in turn could hit the fund’s NAV. Not so long back, such instances have already happened for credit-risk bond funds. So, you need to look at the fund portfolio in order to gauge its risk.

There are about 10 floating-rate bond funds in the market today. While some have been around for a while, they have recently caught the fancy of investors. In the last year, on average, floating-rate funds gave a return of 8.7% which was only the second-best among all debt fund categories. 

As the central bank starts drawing liquidity out of the system, there is a general belief that interest rates could go up thereby benefiting floating-rate bond funds. These funds usually invest in bonds with a tenure ranging between 1-4 years. 

While these funds are best positioned to benefit from rising interest rates, the investor needs to keep a long-term focus in their portfolio construction process. Any attempt to tweak the portfolio in order to benefit from any short-term market trends could actually backfire. 

Takeaway

Floating-rate funds while being well-positioned to benefit from a rise in interest rates also have the challenges of poor liquidity and credit quality. Rather focus your energies on building robust asset-allocation strategies instead of finding ways to benefit from short-term market trends.