Mutual Funds

How Floating Rate Funds are riding on the upturn in interest rates

Maulik Madhu BL Research Bureau | Updated on June 27, 2021

Tata MF is the latest AMC to join the Floating Rate Fund category

Tata Mutual Fund has launched its floating rate fund. The new fund offer closes on July 5, 2021. With the latest addition, the number of funds in this category has gone up to 12.

A floating rate fund must invest at least 65 per cent of its assets under management in floating-rate debt securities. Given the limited availability of floating-rate bonds in Indian market, funds also invest in fixed-coupon securities that are converted into floating rate ones using interest rate swaps (IRS) to meet the 65 per cent limit. IRSs allow two parties to swap interest rates — a fixed rate for a floating one or vice versa. Floating-rate securities typically account for 15-40 per cent of the minimum mandated limit.

Floating rate funds try to capitalise on an expected upturn in the interest cycle. Unlike funds that invest in fixed-rate securities, those investing in floating-rate ones gain from an increase in interest accruals as the floating rate (linked to an external benchmark such as the MIBOR, for instance) gets automatically reset periodically in line with a rise in rates.

For the fixed-rate instruments converted into floating-rate using IRSs, the swap (fixed to floating) helps capture the benefit of higher rates. A part of this gain may, however, get neutralised by the fall in the price of the fixed-rate instruments as rates rise.

Considering that interest rates are expected to rise from here on, Tata MF is trying to cash in on the opportunity through this NFO. There have been a few other floating rate fund launches by other AMCs too in recent times.

Fund features

Tata Floating Rate Fund plans to invest its corpus largely in AAA-rated and sovereign debt papers. The fund is benchmarked to the CRISIL Ultra Short Term Debt Index. The fund duration will currently be kept at slightly over 6-12-months and will be modified over time with changing interest rates. The scheme is labelled ‘moderate risk’ under the SEBI risk-o-meter. You can invest a minimum of ₹5,000 and in multiples of ₹1 thereafter.

Apart from the mandated 65 per cent investment in floating rate debt instruments, a floating rate fund enjoys flexibility on two counts. One, such a fund has the leeway to modify its duration in line with the changing interest rate situation and does not have to keep it within a specified range, unlike funds from categories such as low duration, short duration and the like, that must maintain the scheme duration within a certain range. Higher the duration, higher the interest rate risk.

Today, with rates at near-bottom and inflation remaining high, interest rates are expected to gradually move up, likely from next year. The extent of how much a floating rate fund gains from this will depend not just on the extent of the rate hike but also on how the portfolio is positioned duration-wise.

For example, when the rate cycle is expected to turn up, funds may like to invest in bonds with relatively lower duration (maturity). This will help the fund minimise the capital loss (fall in bond prices as rates rise) on the bonds in its portfolio and enable it to invest in newer higher interest-bearing bonds. Funds may also increase the proportion of floating-rate bonds (either actual or converted) in the portfolio beyond the minimum mandated to add to the interest accruals.

When rates are expected to fall, such funds may do the opposite. For instance, during the rate-cut cycle of 2019 and first half of 2020, ICICI Pru Floating Interest fund upped its average maturity from 0.7 years in January to 1.3 years by September 2019. ABSL Floating Rate fund raised it from 0.6 years to one year in the same period.

The second flexibility for a floating rate fund is that it can freely alter the credit quality of its portfolio, which is not so for all fund categories. In corporate bond funds, for instance, the portfolio must be of a certain minimum credit quality. Hence, there has been wide variation in credit quality across funds in this category.

Nippon India’s floating rate fund has been investing around 95 per cent of its portfolio in AAA-rated and sovereign debt papers for several years.

ICICI Pru Floating Rate fund had 25 per cent of its portfolio in such papers in January 2018 which gradually went up to 71 per cent by April 2021.

So, one must check these before selecting a fund.

Returns

Of the 12 funds in this category, only five have been in existence since 2018 (following SEBI’s re-categorisation) or earlier. HDFC Floating Rate Debt fund is the largest one.

These funds have generated latest one- and three-year returns of 4.8 to 7.0 per cent and 6.2 to 8.7 per cent, respectively.

Published on June 26, 2021

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