New Fund Offer . IDFC Floating Rate Fund NFO: Betting on rate-cycle turnaround

IDFC Mutual Fund recently launched its Floating Rate Fund. The new fund offer closes on February 16.

Such funds must invest at least 65 per cent of their assets under management (AUM) in floating-rate debt securities. The rest can be in debt and money-market instruments other than floating-rate ones. Given the paucity of floating-rate bonds in the market, floating-rate funds (or floater funds) invest in a mix of floating-rate debt instruments and fixed-rate debt papers converted into floating-rate ones using interest-rate swaps (IRS).

About the fund

IDFC Floating Rate Fund will invest 70 per cent of its AUM in AAA, A1+ rated and sovereign and quasi-sovereign papers. It will not invest any corpus in below AA- rated papers.

Like all other floating-rate funds, the scheme does not need to operate within a defined duration bond and will have the flexibility to modify it suitably. It will be benchmarked to the Nifty Low Duration Debt Index, and according to the asset management company (AMC), will be suitable for a minimum investment horizon of six months.

Currently, there are eight floating- rate funds from different AMCs. Today, most have invested a large part of their portfolio in AA+ and above-rated, and sovereign debt papers.

However, this has not always been the case for all the schemes. As of December 2020, the average portfolio maturity of these funds was 1.5-7.9 years. Floating-rate schemes have given one- and three-year rolling returns of 6.5-8.0 per cent and 6.4-8.2 per cent, respectively, over the past seven years. These are similar to that of short-duration funds.

With interest rates at historic lows now, floating-rate funds can benefit from a gradual turnaround in the rate cycle, as and when it happens.

Then, rates on floating-rate instruments in the portfolio get reset. The scheme also gets the benefit of a higher floating rate through the IRSs it has entered into. Here are a few points to consider before you invest.

Interest risk not absent

Even in a rising interest-rate environment, one can’t assume that a floating-rate fund will outperform a comparable maturity categorised fund (such as an ultra-short, low or short-duration fund).

According to Anurag Mittal, Senior Fund Manager, Fixed Income, IDFC Mutual Fund, floating-rate securities are also subject to mark-to-market risk.

When interest rates rise, floating-rate bonds (unlike fixed- rate ones) will see an increase in interest accruals at the next rate reset date. These are referenced to an external benchmark such as the MIBOR or T-Bill rate plus spread.

The revised rate will apply from the next reset, which can happen quarterly or semi-annually, for instance. Longer the maturity of the debt papers, the greater the interest-rate risk, as the bonds will still experience a fall in price (mark-to-market loss), though not to the same extent as that of fixed-rate bonds.

In case of fixed-rate instruments converted into floating-rate ones using IRSs, the swaps will help in getting a higher floating rate which is linked to an external benchmark rate, that will get reset as rates rise. But, some of this higher interest income impact may be neutralised by the fall in price of the fixed-rate instruments in the portfolio, when rates rise.

One party can enter into an IRS — an agreement to swap a fixed rate for a floating one — with another party to benefit from a possible rate rise. The success of this strategy will depend on the fund manager calls going right.

Credit, duration profile

Like some other debt fund categories, floating- rate schemes can vary in terms of credit quality. So, one must check the portfolio credit quality, as higher returns may not be all driven by higher floating rates but also by higher credit risk.

Besides, compared with other debt fund categories such as ultra-short duration funds, low duration funds and short-duration funds, floating-rate funds do not have to follow a defined range of duration. It’s worth checking if the duration is aligned with one’s investment horizon.

Mittal suggests investors look at the index to which the floating-rate fund has been benchmarked, in order to get a sense of the fund’s likely maturity profile (whether ultra-short, low or short- duration, for instance).

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