Floaters on the rise

INVESTMENT COUNTER/ FLOATING-RATE FUNDS - Ideally suited for a rising interest-rate environment.

With interest rates seemingly bottoming out, debt investors find themselves in a spot. On the one hand, debt returns are nothing much to write home about. Scarier still is the fact that in a rising interest rate scenario, future returns from your debt portfolio could even turn negative.

Though debt fund managers are still confidant about higher returns, chances are that debt returns may not outdo bank savings rates by much. So if you still swear by debt, what kind of products should you look for? Given the scenario, floating-rate funds offer a good investment option for die-hard debt fans.

Subscription to floating-rate funds have gone up by more than three times in the past few months and the total subscriptions now amount to nearly Rs 10,000 crore.

The reason: investors are increasingly hedging interest rate risks due to the rise in G-Sec yields. Mutual funds have been loading up their portfolios with floating rate funds or 'floaters', once the risk of higher interest rates became palpable. A floating-rate fund invests in floating-rate instruments and needs to have a minimum exposure of 65 per cent to floating-rate instruments.

Why 'floaters'?

Simply put, floating-rate funds work as a hedge when rising interest rates are threatening to ruin your debt returns. They also serve to protect your capital in a volatile interest-rate scenario, as compared to plain vanilla long-term debt funds.

According to Sameer Kulkarni, head of fixed income at Franklin Templeton Investments, floaters "provide higher stability in terms of investment performance and volatility to an investor's portfolio."

The key to floating-rate funds lies in understanding the inverse price-yield relationship of bonds. Bond prices fall when interest rates rise, and rise when rates fall. Kulkarni notes that the risk of investment value fluctuating with changes in interest rate is minimal as the interest rate on floating-rate instruments is reset periodically.

Ideal for rising rates

The reasons why mutual funds are pushing 'floaters' in the market are obvious. Global fixed-income markets are expecting interest rates to reverse direction. The uncertainty over rate movements have led to volatility in debt markets which means lower returns from debt funds. However, fund managers are not yet expecting domestic rates to move up anytime soon. According to Rajiv Anand, head of investments at Standard Chartered Mutual Fund, the question of a rate hike in India does not arise at least for another 12-18 months. "There is no one-to-one co-relation between global rates and domestic rates," he says.

Given the fact that interest rates have not yet started moving up, how are fund managers aligning their portfolios? "We are not expecting any major policy changes over the near term with regard to interest rates. However, markets have started pricing in higher rates in future, which is reflected in the upward movement in benchmark yields. We have modified the portfolio structure by reducing duration and increasing cash, and adding floating-rate products," says Kulkarni.

Market watchers say it is advisable for investors to allocate a part of their investments to floating rate funds in such uncertain times. Though returns from these funds are normally less than pure debt funds, in volatile markets, 'floaters' are a better bet, as they provide a good buffer against volatility.

Besides, there is the comfort factor associated with returns which are in line with market rates. "Returns of a floating rate instrument are linked to the current yields on debt instruments, in line with market rates," Kulkarni adds.

Floating risks

However, these seemingly risk-free funds do carry some risks. Since interest rates on floating rate bonds reflect the market rate, prices of these bonds do not move up as in the case of fixed-rate bonds, which limits capital appreciation. Besides, there is the obvious risk of the fund earning lower returns because of a fall in interest rates in the future.

Kulkarni says the floating rate paper carries credit risk like any other fixed-rate paper. "It has a slightly higher liquidity risk, as it is not highly tradable. The interest rate risk on floating-rate instruments is minimised as the coupon readjusts to the change in the benchmark interest rate at a periodical interval."

Besides, a floating rate instrument derives most of the returns from the coupon income and little from the price movement, compared to a fixed-rate instrument where price movement can contribute a significant portion of the total return in a volatile interest-rate environment.

According to Kulkarni, unlike the past when interest rates were flat and administered, interest rates now are market-driven. "In such a scenario, it is important for investors to diversify their debt portfolio to protect themselves against volatility caused by interest-rate swings. Floating-rate debt products can help investors reduce this risk," he says.

Anand considers 'floaters' as "funds for all seasons." "They can be used as a surrogate to cash funds, and as long-term funds by someone who holds the view that interest rates are headed upwards," he adds.

 

How floating-rate funds fared
Schemes	NAV (15-Jun-04)	Returns
		1 month	3 months	6 months	1 year
Deutsche FRF	10.30	0.36	1.14	2.23	N.A
Grindlays FRF - Plan C - Super IP	10.09	0.37	N.A	N.A	N.A
Grindlays FRF - Plan D - MF Plan	10.00	0.00	N.A	N.A	N.A
IL&FS Floating Rate Fund - LTP	N.A	N.A	N.A	N.A	N.A
IL&FS Floating Rate Fund - STP	10.38	0.38	1.15	2.32	N.A
JM Floater Fund - LTP	10.34	0.24	0.7	1.68	N.A
JM Floater Fund - STP	10.49	0.37	1.14	2.62	N.A
Kotak Floater	10.47	0.36	1.09	2.26	N.A
LIC MF Floating Rate Fund	10.09	0.35	N.A	N.A	N.A
Tata FRF - LT	10.18	0.32	0.92	N.A	N.A
Birla Floating Rate Fund - LTP	10.53	0.38	1.15	2.28	5.15
Templeton Floating Rate Fund LT	11.55	0.34	1.23	2.41	5.01
DSP ML Floating Rate Fund	10.54	0.39	1.17	2.32	4.97
Pru ICICI Floating Rate Fund	10.61	0.37	1.16	2.3	4.95
Birla Floating Rate Fund - STP	10.50	0.36	1.12	2.26	4.84
Grindlays FRF	10.67	0.34	1.07	2.17	4.84
HDFC FRIF - LTF	10.65	0.33	1.02	1.98	4.25
Grindlays FRF - IP	10.52	0.36	1.13	2.24	3.67
IP - Investment plan, LT - Long term, LTP - Long-term plan, STP - Short-term plan, FRF - Floating-rate fund. Source: www.mutualfundsindia.com