Floating-rate funds: Market experts call for wait-and-watch approach

Floater funds (direct plans) have fetched investors a category average return of 7.8 per cent over the past year. Basing investment decisions solely on past performance could prove counter-productive in this category.

How do they work?  

The Securities and Exchange Board of India (Sebi) guidelines mandate that floater funds must invest a minimum of 65 per cent of total assets in floating-rate instruments. These could be natural or synthetic.

“Natural instruments include those linked to a floating-rate benchmark, such as treasury bills (T-bills), bank MCLR (marginal cost of funds based lending rate), MIBOR (Mumbai interbank offered rate),” says Kaustubh Gupta, co-head of fixed income, Aditya Birla Sun Life Asset Management Company (AMC).

Creating a synthetic floating-rate instrument involves two steps.

“The first is to buy a fixed-rate instrument, and the second is to enter into an interest-rate swap to receive fixed and pay floating, whereby the fixed-rate leg on both the swap and fixed-rate instrument cancel each other out. What remains then is a synthetic instrument,” says Gupta.

 

Drivers of performance

In a rising-rate environment, floating-rate bonds generally outperform fixed-rate bonds due to their periodic coupon resets. 

“The spreads on some of the floating-rate government securities (G-Secs) have been high, which has added to the carry. While RBI rate hikes have paused, these bonds continue to offer significant carry over fixed-rate bonds,” says Chintan Haria, principal–investment strategy, ICICI Prudential AMC.

The global economy remained resilient in 2023.

“These conditions helped floating-rate instruments make some gains since swaps went higher and benchmark rates, including T-Bills, rose higher due to tighter liquidity conditions, increasing the accrual on floating-rate instruments,” says Gupta.

 

Stay put  

Existing investors may continue to hold these funds for some more time. “The yield curve is flattish and interest rates are in the neutral zone. Government floating-rate bonds continue to offer good spread and the possibility of interest rates moving lower remains low,” says Haria.

Adds Gupta: “Bond interest rate swap spreads (synthetic floater) are at near highs, and these are expected to narrow during the year, opening a window for capital gains, which along with the accrual can lead to decent performance.”

Debt market experts share this view.

“It will take at least a few months for the RBI to cut the repo rate. System liquidity is also likely to remain tight for at least a few more months, so there is no hurry to exit,” says Joydeep Sen, corporate trainer (debt markets) and author.

Regarding the right cue to exit these funds, Sen says: “The RBI’s current stance is withdrawal of accommodation. Before it can cut rates, it would have to change the stance to neutral. Investors should take the change of stance as a cue to exit,” says Sen.

 

Should you enter now?

Opinions vary on this question. Fund managers remain bullish. Gupta says contrary to popular belief, a floating-rate fund has the potential to make money in both rising and falling interest-rate cycles if positioned correctly. “On the downward side, a fund can make money by locking into bond-interest rate swap trades when the spread is higher, which will make capital gains when these spreads compress, in addition to playing a little higher duration and accrual in this cycle,” he says.

Other experts, however, suggest caution. 

“RBI rate hikes and system liquidity tightness were the key drivers of performance. RBI rate hikes are, in all probability, over. System liquidity may remain tight for some time but is unlikely to tighten further. Hence, system liquidity driving call money rates further up is unlikely,” says Sen.

Nehal Mota, co-founder and chief executive officer (CEO), Finnovate shares this view. “We are at the peak of the interest-rate cycle currently. With rates likely to head southward in the next 18-24 months, this might not be the ideal time to invest in floating-rate funds,” she adds.