Understanding a Floating Rate Fund

Floating rate fund invests in either floating rate instruments (instruments whose yields change with change in benchmark rates) or in fixed coupon instruments which are converted to floating rate by using Swaps.

Floating Rate fund provides flexibility and self-adjusting feature to the changing interest rate environment. Floating rate fund also gives the flexibility to not only manage interest rate risk through changing allocation to debt instruments (buying different tenure or duration papers), but it also uses another tool in form of swaps to manage duration and at same time choose the optimal mix.

1. WHAT IS A FLOATING RATE DEBT SECURITY?

A floating-rate Bond is a bond that has a variable interest rate as against a fixed-rate bond that has an interest rate that does not fluctuate. The interest rate is tied to a benchmark rate, such as MIBOR (Mumbai Inter-Bank Offer Rate) or the Repo rate, plus a quoted spread.

For e.g., Let’s say we buy a paper with coupon of MIBOR + 200 bps, we know that MIBOR tracks very closely to operating rate (Repo or Reverse Repo). Now if Repo or Reverse Repo is hiked by 25 bps, MIBOR would also go up by 25 bps. That means we will have higher coupon from our floating rate security. Unlike a fixed coupon bond, where the coupon will not change with change in Repo or Reverse repo change.

2. WHAT ARE FLOATING RATE FUNDS?

Floating rate fund invests in either floating rate instruments (instruments whose yields change with change in benchmark rates) or in fixed coupon instruments which are converted to floating rate by using Swaps/Overnight Index Swap (OIS).

As per SEBI categorization a Floating Rate Fund is an open-ended debt scheme predominantly investing in floating rate investments. SEBI regulations mandate a minimum investment of 65% of Total assets in floating rate instruments.

Since there are not many issuers of floating rate bonds in India, the floating rate bond market size is not large enough hence, Mutual Funds make use of derivative instruments like Interest Rate Swaps like Overnight Index Swaps to convert the fixed coupon yielding portfolio in to floating rate portfolio.

3. WHAT ARE OVERNIGHT INDEX SWAPS (OIS)?

Overnight Index Swap (OIS) is a hedging contract between two parties, wherein the two parties exchange or swap the interest payments on a notional principal amount. These contracts can involve fixed or floating rate of interest. Here the floating leg of the swap is linked to an overnight index.

There is no cost involved while entering in to an OIS contract. The OIS Contract have a notional contract value on which one party agrees to pay fixed (the OIS rate) and other party agrees to pay floating rate (Overnight MIBOR rates daily compounded).

At the end of the periodic reset period, the net interest rate differential is exchanged with the Net loss position pays the net gain position.

For e.g., if the overnight MIBOR rate is greater than the fixed OIS rate then the party agreed to pay floating will be the Net payer to the position. Similarly, if the Fixed OIS rate is greater than the Daily compounded MIBOR rate for the period then the Floating Rate receiver pay to the other party.

Illustration of an OIS contract:

4. WHAT ARE THE IMPORTANT THINGS YOU MUST KNOW ABOUT FLOATING RATE FUNDS?

a. Diversifies Fixed Income Portfolio
Unlike a typical debt fund where the return is fixed, a floating rate fund provides diversification to your fixed-income portfolio at a low investment limit. It invests in different types of debt securities with variable interest rates thereby reducing overall portfolio risk.

b. Avoids Duration Risk
Duration risk refers to the risk of loss due to increase in interest rates in the market when you have invested in longer duration fixed-income securities. In a rising interest rate scenario, your investment in a floating rate funds offer lower duration risk as compared to longer tenure fixed-income securities.

c. Return Depends on Benchmark Interest Rate
As discussed earlier, returns from a floating rate fund are linked to the benchmark interest rate. In an increasing interest rate environment, your investment in floating rate funds can give higher returns than other fixed-income funds. However, when the interest rates fall, your returns from a floating rate fund can be lower than other fixed-income funds.

d. Provides Flexibility
The open-ended nature of a floating rate fund can provide you flexibility in terms of entry and exit and the time period of staying invested.

Floating Rate fund provides flexibility and self-adjusting feature to the changing interest rate environment.

Floating Rate Fund aims to utilize the flexibility to manage interest rate risk and enable investors earn enhanced accrual returns. The Fund aims to create a portfolio of optimal credit quality along with lower net duration risk enabling investors to earn competitive accrual returns as compared to similar duration investment avenues.

We believe the fund is well suited for broader upcoming rate cycle and provides a suitable alternative to other debt funds / products.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully