With interest rates slowly tracing their way back to pre-Covid levels, floating rate debt funds — also referred to as floater funds — are in the limelight, of late.

CRISIL’s analysis shows that in the six months ended August 31, 2021, a period that saw flat or rising interest rates, floating rate funds (direct plan) have generated the best returns of 3.40 per cent compared with 1.66-3.10 per cent for other categories of similar tenure and composition.

Not surprisingly, investor interest has surged, with August witnessing net flows of ₹9,991 crore. This is the highest monthly net flows for the category on record since April 2019, when the Association of Mutual Funds in India (AMFI) started detailed disclosure.

What’s more, flows into existing funds and new fund launches, coupled with accrual gains, have taken the assets under management (AUM) of the category to a record ₹94,751 crore at the latest count.

What do they invest in?

According to the definition of the Securities and Exchange Board of India, these funds need to invest a minimum of 65 per cent of their investments in floating rate instruments. In practice, a chunk of these funds consist of synthetic exposures in the form of interest rate swaps such as overnight index swaps (OIS).

A portfolio analysis of floating rate debt funds for August shows that allocation of FRBs (floating rate bonds) in floater funds currently ranges from 0 per cent to around 56 per cent of the schemes’ net asset value, with the rest of the corpus being parked in short- and medium-duration fixed-coupon bonds that are then converted into synthetic floating positions through swaps.

The primary reason for such synthetic exposure is the limited supply of FRBs in India.

As of the June quarter, there were corporate floating bonds for ₹1.74 lakh crore outstanding in the market, which accounted for a mere 4.81 per cent of the total outstanding corporate bond issuances. Similarly, the share of RBI-issued FRBs during last fiscal stood at only 6.5 per cent of total government issuances.

The constrained FRB market in India drives fund managers to use derivative instruments such as OIS to convert the fixed-coupon bonds of varying tenures into synthetic floating positions and thereby meet the regulator’s holding requirement.

What’s fuelling their growth?

Floating rate debt funds fare better than comparable categories in interest rate scenarios such as the current one because they invest a chunk of their monies in instruments such as floating rate bonds or derivatives converting fixed rate-coupon bonds into synthetic floating positions.

Today, though the Reserve Bank of India (RBI) continues to maintain interest rates at all-time lows, its soft interest rate regime seems to be on its last legs as high inflation, a large fiscal deficit, and talk of monetary policy normalisation from major central banks loom large on the horizon. For now, the RBI is taking baby steps towards the exit.

CRISIL expects this calibrated withdrawal of liquidity to continue and gain momentum as more certain signs of economic recovery become visible. The expectation, though, is predicated on growth staying on track.

A two-stage signalling is expected by the end of this fiscal: a change in stance from accommodative to neutral, followed by a hike in the repo rate by 25 bps to 4.25 per cent.

This, in turn, will push domestic yields upward from current levels. After falling from a high of nearly 6.70 per cent pre-pandemic to near 5.70 per cent post-lockdown, yield on the 10-year government security (G-sec) has risen again to trade around 6.20 per cent levels. By March 2022, we expect this yield to firm up to 6.50 per cent.

Interest rates and bond prices have an inverse relationship – rising interest rates beat down the prices of bonds and shore up their yields, and this holds especially for long-maturity papers.

However, OIS swaps provide market-linked returns as their rates are reset periodically based on prevailing interest rates. An OIS can be categorised into a fixed leg (where the investor pays fixed coupon) and a floating leg (where a daily compounded OIS return is received).

As seen in the accompanying graph, OIS rates have been on an uptrend over the period of the study. These increased OIS rates, coupled with spreads, have lifted the swap value and, in turn, buoyed the returns of floating rate fund schemes.

PO19CrisilOISratescol

Tread with caution

Among other advantages, because of their structure, floating rate debt funds provide investors a hedge against rising interest rates. Also, akin to other debt mutual fund categories, a holding period greater than three years provides indexation benefit, thus reducing the overall tax liability on investment gains.

Added to this, the government’s plan to borrow as much as ₹48,000 crore through FRBs, out of its total auction borrowing of ₹7.24 lakh crore targeted in the first half of this fiscal, is expected to promote healthy participation in this avenue.

Investors should, however, note that the performance of FRBs is subject to factors such as timing of entry, reset dates and liquidity of these instruments.

These funds are also vulnerable to the risks — of credit, interest and liquidity — typically associated with fixed-income instruments, which can result in capital losses in the short term. To give context in terms of credit quality, as per August 2021 portfolio, assets in AAA-rated, cash and government-backed securities ranged between 80-100 per cent and those in –AA and below rated instruments at around 0-5 per cent for the schemes in the category,

To surmise, investors need to look into the specific portfolios before making an investment decision. Lastly, a sharp rise in yields and/or delay in roll-back of loose monetary policy by the central bank could impact returns.

The writer is Director, Funds Research, CRISIL

comment COMMENT NOW