Aditya Birla Sun Life Floating Rate Fund: The comfort of stable returns

Debt fund investors wanting steady returns and looking to lower risk in interest-rate movements can consider floating-rate funds.

There are currently seven funds within the category that invest at least 65 per cent of their portfolios in floating-rate instruments. These also include fixed-rate instruments converted to floating-rate exposures using swaps/derivatives. The balance assets are invested in fixed-rate papers and money-market instruments.

Aditya Birla Sun Life Floating Rate Fund has been one of the top-performing schemes in the category. It has outperformed the category over one-, three- and five-year time-frames, clocking a compounded annualised return (CAGR) of 9.3 per cent, 8.1 per cent and 8.4 per cent, while the category generated 9 per cent, 7.7 per cent and 7.8 per cent returns, respectively.

Investors with a moderate risk appetite can consider investing in the fund with a time horizon of 1-2 years.

Investment strategy

Floating-rate debt instruments are issued by the Central and State governments, corporates, and PSUs with interest rates that are reset periodically, say monthly, quarterly or any other periodicity. The rates are reset with respect to a reference rate. For instance, in India, some floating bonds have a coupon rate of the Mumbai Interbank Offer Rate (MIBOR) + 50 basis points.

Issuance and trade of floating-rate bonds have been limited in India. Many companies do not prefer issuing such bonds since they expose them to rate risk with uncertainty around the interest outgo. According to industry sources, issuance of floating-rate bonds comprises less than 10 per cent of the entire Indian bond market universe.

So, how do floating-rate debt funds manage to meet the mandate of investing at least 65 per cent in such bonds?

Five out of the seven funds in the category — Aditya Birla Sun Life, ICICI Prudential, HDFC, Nippon India and Kotak floating rate funds — have managed to hold more than 65 per cent in floating-rate related instruments. While the exposure to actual floating-rate bonds is limited to 10-20 per cent, these funds adopt derivative strategies to meet the 65 per cent threshold limit.

The fund managers of these schemes enter into swap contracts in the debt market (mostly with large banks; hence, there is no counter-party risk) to convert their fixed-interest instruments into floating-rate instruments.

For instance, if a fund manager expects interest rates to rise, she swaps her fixed-income instrument with a floating-rate debt paper to hedge the portfolio. Interest Rate Swap (IRS) is a derivative product used to manage interest-rate risk.

Put simply, assume a fund manager holds a fixed-rate bond paying 6 per cent annually. She expects the interest rate to rise going ahead. As you might be aware, the value of a bond decreases if the interest rates rise.

So, she enters into an IRS with another market participant and agrees to pay, say, 5.5 per cent annually, while the counter party agrees to pay her a floating rate of, say, MIBOR + 0.5 per cent.

When the interest rates rise in the economy, the MIBOR rates also move up and thus the fund manager ends up getting higher yields.

As per their latest portfolios, Aditya Birla Sun Life, ICICI Prudential, Kotak, Nippon India and HDFC floating-rate funds have allocated around 45 per cent, 58 per cent, 40 per cent, 59 per cent and 61 per cent, respectively, to swap strategies.

Note that while this strategy reduces the interest-rate risk caused by rise in interest rates, it also restricts the profit in case interest rates decline (called spread risk). Hence, you cannot expect superior return from these funds. These schemes are suitable especially during rising-rate scenarios. But even in volatile markets, such as the one now, such funds offer the comfort of stable returns.

Looking at their performance during various rate cycles over the past five years, it can been seen that floating-rate funds have managed to outperform (though marginally) comparable categories such as ultra-short-duration, low-duration, short-duration and money-market funds (see graph).

ABSL Floating Rate

Aditya Birla Sun Life Floating Rate Fund has delivered 7.8 per cent CAGR as measured by the three-year rolling returns calculated from the past five years’ NAV history; the category generated 7.2 per cent.

The fund emphasises on safety, liquidity and returns while managing the portfolio. Over the last two years, it has invested only in the highest-rated AAA bonds and government securities (the only AA+ rated bond in the latest portfolio is Cholamandalam Investment and Finance). This mitigates credit risk.

The scheme holds around 20 per cent in floating-rate bonds and 45 per cent in converted floating-rate bonds. This lowers interest-rate risk. The average maturity of the portfolio is 4-18 months.

It is rated five-star by BusinessLine Portfolio Star Track MF Ratings.