Floating rate funds may not help you during reversal in rate cycle

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Interest rates in India are at historic lows. At around 6%, the 10-year Government of India bond yield is close to a decade’s low point. However, with inflation rising and a large fiscal deficit to provide for, there are growing fears that the rate-cutting cycle may soon reverse.

A rate hike cycle inflicts losses on most types of debt funds. This is because bond prices drop when interest rates rise. Floating rate bonds are supposed to protect investors from such hikes because the interest they receive goes up with rising interest rates in the economy. However, floating rate funds may not deliver fully on this assumption, say fund managers.

To understand floating rates, consider a home loan from a bank, where the bank usually charges a floating interest rate. This interest rate is in many cases tied to the RBI’s repo rate. For example, if the repo rate is 4%, your bank will charge 4% plus a spread of say 5% on your home loan. If the repo rate is cut by 1%, other things being equal, your home loan interest rate should also fall by 1%.

A floating rate fund tries to replicate this kind of payout for mutual fund investors by investing in bonds whose coupons (interest payments) change according to overall interest rates in the economy. This is meant to protect investors from taking losses if rates are increased. However, fund managers warn of a number of risk factors that prevent this model from working.

A rate hike cycle inflicts losses on most types of debt funds.

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A rate hike cycle inflicts losses on most types of debt funds.

Suyash Choudhary, head, fixed income, IDFC Asset Management Company, spoke about this subject in a recent interview to CNBC TV18. IDFC AMC is launching a floating rate fund, but is at pains to point out that this is more a credit-lite strategy with low maturity rather than a play on the rate cycle turning.

“It is almost a convenient narrative that a floating rate fund is coming along just when interest rates are bottoming out. Let me assure you that is not the intent at all. The last one-and-a-half months have seen extraordinary volatility in fixed income. Floating rate funds have not navigated that particularly well. Ultimately, what matters is the net duration that you are running in the fund… if your net duration is positive, that is the unit of risk and that will determine how your NAV (net asset value) will fluctuate as per changes in interest rates,” he told CNBC TV18.

According to him, a minimum 70% of the fund will be in high-quality paper such as debt rated AAA, A+ or sovereign debt and up to 30% can be in lower-rated paper with the condition that the fund won’t buy anything less than AA- at the point of investment.

Floating rate funds have a certain level of portfolio duration, which makes them vulnerable to interest rate hikes. The higher the modified duration of a debt fund, the more sensitive it is to interest rates. The average maturity (an indicator of duration risk) in floating rate funds ranges from 1.34 to 4.72, shows Value Research data.

“The second point to remember is that in India, the availability of floating rate instruments is quite constrained and hence whatever exists has a reasonable amount of liquidity risk,” Choudhary added.

According to fund managers, several floating rate funds implement their mandates through interest rate swaps. These are derivative instruments that exchange a fixed set of cash flows to floating cash flows.

According to Rajeev Radhakrishnan, CIO, fixed income, SBI Mutual Fund, this involves basis risk. This is the risk that the interest rate swap does not fully compensate for any change in the underlying bond’s yield, he said.

Finally, some floating rate funds follow a wholly different strategy that may not be apparent to investors who are not clued into the mutual fund industry. For instance, Nippon India Floating Rate Fund, which had an AUM of 16,057 crore as of 31 January and an average maturity of 2.58, follows a ‘roll down’ strategy. It had a modified duration of 1.79 years.

This strategy involves buying a portfolio of bonds and holding them to maturity. It allows investors to ‘lock-in’ a particular portfolio yield and then get returns close to the yield if they hold the fund till the target date. The strategy is more commonly used in fixed rate funds than floating and may not be in sync with the generally understood premise of ‘floating rate’.

“While floating rate funds can provide some hedge in a rising interest rate scenario, these funds have a dilution on the credit quality. The fund manager’s view about the interest rates plays an important part and thus, these funds are not meant for the portfolio of every investor. They can be considered by savvy investors who can undertake some bit of both—interest rate and credit risk,” said Prableen Bajpai, founder, FinFix Research and Analytics Pvt. Ltd.

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