Typically, an investor plan his mutual fund investments in equity mutual funds or debt-related instruments based on their risk tolerance levels. An investor with lower risk tolerance levels and short term goals prefers debt funds as they are much less volatile when compared to equity funds. Debt mutual fund investments have several categories like income funds, gilt funds, dynamic funds, floater funds and many more
What are Floater Funds?
A floating rate debt fund is a fund that invests more than 65% of its total assets in floating rate instruments. A floating rate instrument can be corporate bonds and debt instruments or loans from companies that have variable or floating interest rates. In other words, the floater funds do not have a fixed coupon rate.
Fluctuating interest rates in the market primarily determine the rate of interest of floating funds. Any change in the repo rate by the Reserve bank of India (RBI), affects the return of any debt instrument. Every floating rate instrument has a specific benchmark. However, the interest rate of these financial instruments changes in accordance with a change in the benchmark rate.
As the market lending repo rate increases, the interest rate of these floater funds also increases. This change can be seen in NAV units of these funds. Thus, this allows higher returns to the investor.
Therefore, these funds aim to benefit from the fluctuating interest rate situation. One can choose to invest in these funds when the interest rates are rising in the country. The taxation for these funds is similar to debt mutual funds.
Types of Floater Funds
Short-term Floater Funds
These funds primarily invest in short duration debt instruments. For instance, T-bills, certificate of deposits, government securities, etc. These instruments have short duration maturity and are highly liquid in nature.
Long-term Floater Funds
These funds invest in long term debt securities. These instruments have a long term maturity period. The portfolio of these funds majorly consists of floating rate debt instruments. The remaining part of the portfolio is either invested in money market instruments or fixed-rate securities.
How do floater funds work?
In comparison to bonds like corporate bonds which have a fixed coupon rate, floater fund securities have variable or fluctuating interest rate. Every floating rate instrument has a specific benchmark. The interest rate of a benchmark fluctuates. Subsequently, the interest rate of the floating instrument also fluctuates as per the benchmark.
Generally, one can observe that, as interest rates increase in the debt market, the interest rate of floating instruments rises too. In other words, as the repo rate increases, the market lending rate also increases. This affects the return of all the market-linked debt instruments.
As the floater fund consists of these instruments, they yield a higher return to investors. Thus, investors switch to floating rate funds when the interest rates are rising in the country. The fixed income rate funds lag in such cases. Hence, These funds offer better returns in comparison to fixed-income rate funds.
Features of Floater Funds
A diversified portfolio of debt securities
The diversification of a portfolio is essential in the long term. The portfolio of consists of both floating rate instruments and fixed-income securities. However, 65% of their primary assets are invested in floating rate securities. These instruments yield better returns during rising interest rate movement. The remaining part of the fund consists of fixed-income securities.
Floater funds are for lower risk tolerance investors. Comparatively, the floater fund is a safer investment option. However, there is credit risk involved in any debt instruments, including floater funds. The risk occurs when the bond defaults its payment dues. One can choose to invest in securities that have a high credit quality or rating where the risk of default is minimal.
In comparison with other fixed-income instruments, bank deposits, bonds, etc. floater funds yield better returns in the long run. These funds have low volatility when compared to short term debt funds. One can leverage the benefit in it during rising interest rates in the economy. This opportunity can yield better returns, although it is not justified with higher interest rate risk.
The taxation is as per the usual for debt mutual funds. The debt mutual fund has two types of tax, i.e. short term capital gains and long term capital gains.
If the holding period of the fund is less than three years, it is called short term capital gains. The capital gains tax will be levied as per the investor’s income tax slab rates.
If the holding period of the fund is more than three years, it is called long term capital gains. The capital gains tax liability will be 20% with indexation benefit or 10% without indexation.
Open-ended Debt Scheme
In an open-ended fund, the investor can enter or exit the fund anytime after the (New Fund Offer) NFO. The investor can decide the entry and exit based on his needs, financial goals and investment purpose. The investment can be in the mode of SIP investment or Lump-sum. However, one can invest only in lump sum in these funds and not SIP investment.
Who should invest in floater funds?
A floater debt fund is highly sensitive towards interest rates. It moves in proportion to the current benchmark rate. The return from these funds is based on market conditions. RBI adjusts the repo rate based on the economic situation of the country. In case the interest rates fall in the country, the floater fund can deliver lower returns when compared to other fixed-income funds.
This fund can be an additional option for investors for fixed income investments. These funds come with credit risk attached with them as there can be default in payment of the underlying security. Also, it is essential to analyse and predict the market economy while making a decision. Further, an investor should also be able to tune his investment to the financial goal in the predicted market conditions. An investor whose financial goals matches with the fund should invest in floater funds.
Difference between floater funds and money market funds
Both floater funds and money market funds fall under the category of debt mutual fund scheme. However, there are some differences between these funds.
- A floating fund invests at least 65% of its corpus in floating rate instruments and some in fixed income securities. Comparatively, liquid funds invest in very short term maturity instruments like commercial papers, t-bills, etc. These instruments are held for a fixed time period up to their maturity.
- Usually, the redemption of any debt fund or equity mutual funds take T+3 days. Only for liquid funds, the redemption time is T+1 day.
- Floater funds are suitable for the medium duration for investment up to a few years. Liquid fund is ideal for the duration of a few days or a few months.
- The returns are lower in liquid funds in comparison to floating rate funds as investments are for the short term.
- A liquid fund can invest in short term instruments, whereas a floater fund can invest in both short and long term instruments.
- With an interest rate rise in the economy, floating rate funds will rise immediately because of adjusting coupon rates. However, in the case of liquid funds, the return will not increase immediately as the coupon rate is fixed.
Limitations of floater funds
Investors with a low-risk tolerance level might find floater funds attractive, especially those who are looking for investment options and other equity schemes. Nevertheless, there are certain limitations associated with these funds. Every individual must be aware of these before investing.
The return on investment is majorly dependent on the current interest rate scenario in the economy. Any change in the repo rate by RBI, it affects the rate of bonds, government securities and other debt instruments. RBI decides the change in repo rate based on the current market condition. An increase in repo rate means an increase in the rate of these debt instruments, consequently increasing the yield of the floater fund. However, the returns floater funds cannot be anticipated in advance. Therefore, the risk associated with the interest rate for floating rate instruments is uncertain.
Investors who are willing to opt for floater funds must ensure their ability to understand and accept this risk. In comparison to equity funds, they are less volatile, but there is a credit risk associated with it. One should be thoughtful while choosing funds considering the credit quality risk.
Floater Funds are mandated to invest a minimum of 65% of total assets in Floating Rate Instruments. This is a relatively small category with a limited number of funds.
We do not recommend funds in this category since we believe that the potential incremental return is not justified by the higher interest rate risk.