Rearview mirror investing can be perilous in floating-rate funds

Investors should opt for them when rates are expected to climb, not now when they are largely over

With a category average return of 7.53 per cent (for direct plans), floating-rate fund is the best-performing debt fund category over the one-year period. Thirteen funds within this category manage assets under management (AUM) of Rs 63,267 crore. The advice that investors should not go by past returns is especially pertinent to this category.

How do they work?

According to the Securities and Exchange Board of India’s (Sebi) definition, floating-rate funds must invest at least 65 per cent of their portfolios in floating-rate instruments. “These could be government securities (G-Secs) and corporate bonds. Floating-rate securities are bonds that have a variable coupon, equal to a money market reference rate, like the MIBOR (Mumbai Interbank Offer Rate) or treasury bill (T-bill), plus a fixed quoted spread. These bonds aim to hedge against rising interest rate risk,” says Manish Banthia, chief investment officer, fixed income, ICICI Prudential Asset Management Company.

Due to the limited supply of floating-rate securities, the regulator permits the use of synthetic products. “Here, the fund manager holds fixed-coupon instruments in the portfolio and then does a swap deal in the overnight index swap (OIS) market. The asset management company (AMC) pays a fixed coupon and receives a floating-rate coupon, thereby transforming its fixed-coupon instruments into floating-rate instruments,” says Joydeep Sen, corporate trainer (debt markets) and author.

Funds suited for rising rate scenario  

The Reserve Bank of India (RBI) has raised the repo rate by 250 basis points since May 2022. Says Banthia: “Floating-rate bonds do better than fixed-rate bonds in a rising rate scenario.” He explains that as the benchmark rate moves higher, so every six months the coupons that accrue to investors, too, keep rising.

Contrary to popular perception, however, these funds don’t gain immediately from rate hikes. Suppose that the benchmark for the floating-rate instrument is Mibor and the coupon is payable every six months or one year. So, the fund will receive the coupon after this period. If the fund has invested in a synthetic product, again, the differential — between the fixed-rate coupon and the agreed-upon floating rate coupon — will be settled after six months or one year (depending on the terms of the deal). In other words, the gains from rising rates accrue to these funds with a lag. “One explanation for the current good returns of these funds could be that the RBI rate hikes started in May 2022. The Mibor has gone up. Perhaps the benefits are accruing to funds now,” says Sen.

Pros and cons

These funds do well when rates rise. “If one gets the interest rate cycle right, one can make decent returns,” says Abhishek Kumar, a Sebi-registered investment advisor (RIA) and founder, SahajMoney.

On the flip side, when a rate hike happens, their portfolios do witness a mark-to-market impact. “Suppose that the fund has invested in synthetic products. The portfolio will still hold fixed-coupon bonds. When rates rise, there will be an immediate adverse impact, and the fund’s return will dip initially. This will be made up when the gains accrue later,” says Sen.

These funds falter in a falling-rate scenario. Says Kumar: “The RBI changes interest rates according to the Monetary Policy Committee’s (MPC) inflation targeting mandate. Once it has brought inflation under control, it will stop raising rates. The rate cycle will subsequently turn against these funds.”

Some investors want certainty in their returns from debt funds (which target maturity funds provide). Says Nehal Mota, co-founder, Finnovate: “In these funds, with at least 65 per cent of the portfolio in floating-rate bonds, predicting the return is not possible.”

Investors could occasionally face unexpected interest-rate risk in them. “Sometimes, the investor may expect interest rates to rise, but an event like, say, Covid-19, could force the central bank to cut rates steeply.”

Should you invest now?  

The consensus view currently is that rate hikes are largely over. “Currently, the case for investing in a floating-rate fund is not strong,” says Sen.

Mota, too, is of the view that with rates expected to begin declining over the next 12-18 months, investors will be better off investing in longer-duration funds to gain from declining rates.