When interest rates have been falling for a very long time (almost since the beginning of 2015) nobody really talks about floating rate funds. That is because any rate cut leads to a fall in yields on bonds and it results in bond price appreciation. As a result bond holders and bond fund holders tend to benefit substantially when rates are falling. But the reverse holds true when rates are rising. As yields go up the price of the bond falls and that means capital losses for bond holders and bond fund holders. One of the options that investors can choose is to invest in floating rate funds. So what are floating rate funds? When do floating rate funds work and what are the key benefits of floating rate funds? Remember, floating rate funds work best when rates are headed up. Before we get into the concept of floating rate funds let us first delve on why we believe that rates could be headed up in India..
Why rates could be headed higher in India
Interest rates and bond yields are normally a function of CPI inflation or retail inflation. The inflation has been on an uptrend for the last 6 months and that is a classic preparatory move ahead of a likely rate hike. The bond yields of 10-year benchmark bonds have gone up by 100 basis points from 6.5% to 7.5%. That is indicative that the markets are expecting higher inflation and also that RBI may contemplate rate hikes during the year.
There is also the big worry over what the US Federal Reserve will do during the year. It is already estimated that the Fed could hike rates by 75-100 basis points during the year 2018. That means the RBI will be under pressure to ensure that the narrowing of the yield gap does not result in risk-off trading by foreign portfolio investors. To maintain this gap, the RBI may also be constrained to hike rates to ensure that debt outflows do not become a worry. Either ways, there is a strong case for a rate hike in 2018.
Coming back to the concept of floating rate funds
What do we understand by floating rate funds? Floating rate funds are debt funds that invest in floating rate debt. There are bonds that pegged to a certain benchmark and whenever the yield goes up beyond a range the rate on return on these floating rate bonds is also adjusted upwards. This adjustment is done immediately and seamlessly and thus in a rising interest rate scenario, the yield on these floating rate bonds actually outperforms other forms of bonds that pay fixed rates of interest. Floating rate funds will only work when the interest rates are moving upwards and the yields are also headed higher. In most of the other cases, floating rate funds will tend to underperform the other classes of funds.
Typically floating rate funds invest 60% to 100% of their corpus in floating rate instruments. Hence they give you a natural hedge in times of rising interest rates. However, these floating rate funds cannot work when rates are falling, which is one of the reasons why floating rate funds have done too well in India. That is because; India has had much longer tenures of falling rates than rising rates.
Source: Economic Times
As the table above depicts the yields on floating rate funds in India have been in the range of 6-8% on an average. In this case, the yields are on the higher side as we have seen yields in the market going up sharply across the maturity spectrum in the last 6 months. The floating rate fund works best only when the rates are rising and not otherwise.
Making a choice – Floating rate funds versus liquid funds
There is one more option in front of bond fund investors. During times of rising yields in the market, the liquid funds also adjust their yields upward. The only difference is that it happens with a gap and not seamlessly as in the case of floating rate funds. However, liquid funds are already a part of your portfolio for liquidity and you can handle rising rates by increasing your exposure to liquid funds instead of getting into floating rate funds. This will ensure that your interest rate risk is almost nullified with minimal collateral damage to your portfolio. Of course, yields on liquid funds are likely to be lower than what floating rate funds can give when rates are rising. But if you add the cost of exit and entry, the net benefit is quite minimal. A much more pragmatic way of handling the risk of rising rates and yields in the bond market is to increase your exposure to liquid funds. That may not be as precise a choice as getting into floating rate funds but it is good enough!