With interest rates slowly moving back to pre-pandemic levels, floating-rate debt funds are in the limelight. A lot of inflows have come into floater funds recently, especially from corporate investors and HNIs. Should retail investors take the bait as well?
What are floater funds?
Floater funds, as per SEBI regulations, invest at least 65% of their portfolio in floating-rate bonds.
Unlike fixed-rate bonds in which investors receive fixed interest during the tenure, in the case of floating-rate bonds, coupon rates vary and are linked to an external benchmark rate.
For instance, a coupon rate of a bond could be 1% plus MIBOR (Mumbai Interbank Offered Rate) rate. MIBOR is the interbank rate at which banks borrow unsecured funds from one another and which keeps fluctuating based on liquidity situations in the economy.
So, whenever MIBOR rises, the NAV of floater funds also rises as now the coupon rates are revised and higher interest payments are contributed towards the fund NAV.
On the other hand, if MIBOR falls, the NAV of floater funds aren’t impacted as much as compared to a medium or a long-term debt fund. That is because only the interest payments are lowered for a floater fund in the future.
This is as against a regular debt fund which also has to adjust its current NAV to reflect lower interest payments on its bond holdings throughout its tenure.
Bond yield and its prices move in opposite directions.
While it all might seem a win-win for investors of floater funds, it has some practical challenges:
A limited supply of floating-rate bonds
The supply of floating-rate bonds is limited. Only about 5% of the total outstanding corporate bond issuances in the Indian debt market are of floating-rate nature.
Similarly, according to Crisil data, the share of RBI-issued floating-rate bonds during the last fiscal stood at only 6.5% of total government issuances.
Due to limited supply, fund managers of floating rate funds are forced to use derivative instruments such as Overnight Index Swaps (OIS).
These instruments convert the fixed-coupon bonds of varying tenures into synthetic floating positions. This helps meet the regulator’s holding requirement.
Due to these liquidity constraints, there are only 12 floater funds in the market today.
Fund benchmark and strategy
The floater funds make money only when the benchmark interest rates rise. At the shorter end, MIBOR, the overnight interest rates, don’t move the way Treasury bill (T-bill) and Government securities (g-sec) rates do. T-bills and G-sec vacillate much more with market sentiments than of MIBOR.
Moreover, there is an element of basis risk – the risk that the interest rate swap does not fully compensate for any change in the yield of the underlying bond.
Last but not the least, a lot depends on the fund strategy as well. Higher duration means that fund NAV rises (or falls) much more with changes in interest rates. As of October 31, floater funds had varied duration ranging from 1.2 to 7 years.
The interest rate in the economy is hovering near its multi-year low – the 10-year benchmark G-sec yield is currently at 6.3% per annum. With the economy slowly recovering from the pandemic effect, RBI is unlikely to hike rates in quick succession.
On the other hand, a higher fiscal deficit is also threatening to push inflation rates further high, which in turn could keep interest rates higher.
While there are chances of interest rates going up in the medium-term, a lot depends on the RBI strategy.
What should investors do?
Investing just because interest rates are going to rise, might not be a great investment strategy. Most retail investors are better off staying away from tactical allocations. Rather, stick to the asset allocation that is in line with your financial goals under consideration.
Liquid, ultra-short-term funds, and even fixed deposits suit most retail investors for their debt allocations. It will preserve capital while also taking care of liquidity needs. Equities in turn could work towards improving overall portfolio returns over the long term.
Floater funds gain from a rising interest rate scenario. However, a poor supply of floating-rate bonds brings an element of liquidity-related risk to these funds. Therefore, stick to the tried-and-tested ultra-short-term and liquid funds for your debt allocations.