Only savvy investors should enter into floating-rate funds: Analysts

Select a debt fund whose average duration is lower than the investment horizon

Interest rates could harden in the near future. One category that can protect investors from the price volatility seen in most debt funds in such a scenario is floating-rate funds. Ten fund houses currently offer them and have cumulative assets under management of Rs 69,730.9 crore. The new fund offer of Tata Floating Rate Fund, which closes on July 5, is also underway.

Rates could rise   

Consumer Price Index (CPI)-based inflation has risen over the past six months. It stood at 6.3 per cent in May, crossing the Reserve Bank of India’s comfort zone.

Commodity and fuel prices have risen substantially, raising input costs. Experts feel inflation may not abate quickly. Some fund houses expect CPI-based inflation to average 5.9-6 per cent this year.

Globally, economies are on the mend and central banks have started speaking of normalising monetary policy. The Indian economy has been hit hard by the second wave of the Covid-19 pandemic. Sooner or later, the policy will have to be normalised here as well. In such a scenario, rates could start moving up gradually.

How do these funds work

Floating-rate funds invest in two types of instruments.

The first is pure floating-rate bonds that offer a rate equal to the benchmark rate plus a spread. But such instruments are not widely available in India. Fund managers instead invest in fixed-rate bonds and then convert them into floating-rate ones by using interest-rate swaps.

Contain volatility well

In a rising rate scenario, most debt funds (except short-duration ones) see mark-to-market losses. Floating-rate fun­ds are self-adjusting in nature. The interest rates of bonds held by them reset in line with rising rates. 

“Investors in these funds escape the volatility they would otherwise suffer in most other funds,” says Akhil Mittal, senior fund manager, Tata Asset Management. According to him, investors can expect risk-adjusted returns from this fund that are better than what they would get from a low-duration fund (a fund with six months to one-year average duration).

A few risks

These funds do well in a scenario where interest rates rise, pause, and then rise again. That scenario may not materialise.

“The central bank may at best undertake a few hikes. But rate hikes may not sustain. Our interest rates are likely to head lower in the medium- to long-term. Our 10-year benchmark rate of 6 per cent is much higher than the 0-2 per cent rates prevailing in many countries,” says Arnav Pandya, founder, Moneyeduschool. Active fund management calls - based on predicting interest-rate movements - can go wrong.

When interest rates see a unidirectional decline, funds with fixed-rate portfolios are likely to do better.

“Short-duration funds (1–3-year Macaulay Duration) and other higher-duration categories are likely to do better in such a scenario,” says Ankur Kapur, managing partner, Plutus Capital, a Securities and Exchange Board of India-registered investment advisory firm. Very few floating-rate instruments are available, so fund managers have to keep entering into swap contracts.

“The returns on these funds will hinge on the kind of swap agreements fund managers are able to enter into and whether they are able to get the desired net returns using them,” says Pandya. The more complicated nature of these funds also goes against them.

What you should do

Most investors should stick to a strategy of placing 75-80 per cent of their debt fund allocation in lower-duration funds that take minimal duration or credit risk.

According to Kapur, “Lower-duration funds invest in instruments that mature within a short time frame. Their coupons also reset to higher levels when interest rates move up.” Alternatively, select a fund category that has a slightly lower average duration than your investment horizon.

Only savvy investors, or those who have an advisor, should enter into these funds.