How Floating Rate Funds Benefit From Rising Interest Rates

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Tata Mutual Fund launched its variable rate fund. The new fund offering ends on July 5, 2021. With the latest addition, the number of funds in this category has increased to 12.

A floating rate fund must invest at least 65 percent of its assets under management in floating rate debt securities. Given the limited availability of floating rate bonds in the Indian market, the funds also invest in fixed coupon securities which are converted into floating rate securities using interest rate swaps (IRS) to meet the limit. by 65%. The IRS allows two parties to exchange interest rates – a fixed rate for a variable rate or vice versa. Variable rate securities generally represent 15 to 40% of the minimum mandatory limit.

Floating rate funds attempt to capitalize on an expected upturn in the interest cycle. Unlike funds that invest in fixed-rate securities, those that invest in variable-rate securities benefit from an increase in accrued interest because the variable rate (linked to an external benchmark such as MIBOR, for example) is automatically reset periodically in accordance with a rate hike.

For fixed rate instruments converted to variable rate using IRS, the swap (fixed to floating) allows the benefit of higher rates to be captured. Part of this gain may, however, be offset by the fall in the price of fixed-rate instruments as rates rise.

Considering that interest rates are expected to increase from now on, Tata MF is trying to take advantage of the opportunity through this NFO. There have been a few other floating rate fund launches by other AMCs lately.

Fund characteristics

The Tata Floating Rate Fund plans to invest its corpus largely in sovereign debt securities and rated AAA. The fund is referenced by the CRISIL Ultra Short Term Debt index. The duration of the fund will currently be maintained at just over 6 to 12 months and will change over time depending on changes in interest rates. The program is labeled “moderate risk” under the SEBI risk-o-meter. You can invest a minimum of 5,000 and in multiples of 1 thereafter.

In addition to the mandatory 65 percent investment in floating rate debt instruments, a floating rate fund benefits from flexibility in two respects. First, such a fund has the flexibility to change its duration according to the evolution of the interest rate situation and does not have to keep it within a specified range, unlike funds in categories such as low duration, the short duration, etc., which must keep the duration of the diet within a certain range. The higher the duration, the higher the interest rate risk.

Today, with rates near trough and inflation still high, interest rates are expected to rise gradually, possibly starting next year. The size of the gains of a floating rate fund will depend not only on the size of the rise in rates, but also on how the portfolio is positioned in terms of duration.

For example, when the rate cycle is expected to recover, funds may wish to invest in bonds with relatively shorter duration (maturity). This will help the fund to minimize the capital loss (fall in bond prices when rates rise) on the bonds in its portfolio and allow it to invest in new bonds with higher interest rates. Funds may also increase the proportion of floating rate bonds (real or converted) in the portfolio beyond the minimum mandated to increase accrued interest.

When rates are expected to fall, these funds can do the opposite. For example, during the rate-cutting cycle of 2019 and the first half of 2020, the ICICI Pru Floating Interest fund increased its average maturity from 0.7 years in January to 1.3 years in September 2019. The ABSL Floating Fund Rate increased it from 0.6 years to one year. in the same period.

The second flexibility for a variable rate fund is that it can freely modify the credit quality of its portfolio, which is not the case for all fund categories. In corporate bond funds, for example, the portfolio must have a certain minimum credit quality. As a result, there have been large variations in credit quality among funds in this category.

Nippon India’s floating rate fund has for several years invested around 95 percent of its portfolio in sovereign and AAA-rated debt securities.

The ICICI Pru Floating Rate fund had 25 percent of its portfolio in such papers in January 2018, which gradually increased to 71 percent in April 2021.

They should therefore be checked before selecting a fund.

Return

Of the 12 funds in this category, only five have existed since 2018 (following the re-categorization of the SEBI) or before. The largest is the HDFC floating rate debt fund.

These funds generated the latest one- and three-year returns of 4.8-7.0% and 6.2-8.7%, respectively.

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