Should investors invest in floating rate funds?

The current interest rate scenario is in a difficult position. While the borrowers are benefitted due to the lower cost of capital, it comes at the cost of the savers, who are trying to eke out the best of the available rates. This is even as the inflation starts to pick up which being acknowledged by the Reserve Bank of India (RBI), remains a lesser priority for now. Ensuring the growth momentum that's being built up in the last few months has been the top criteria across the central bankers of the world even as they try to put a lid on the possible defaults. Incidentally this is driving the savers to take undue risks to extract that extra return from their capital.

Also, most of the short-term options aren't attractive in terms of the returns and investors aren't able to take any chances with the medium term to longer term options as that would possibly locking them out of better future returns. This is not endemic to India, but across the world, fixed-income investors are facing the same concern. The world is currently in the biggest ever ultra-low interest rate regime with liquidity floating around at an unprecedented level, making all assets prices to soar in this 'everything boom'. Moreover, many investors feel that the interest rates are bottomed out and the rate regime could be on ascent from here.

So, how to benefit from this situation or how to generate better risk adjusted returns in this scenario? Investors could take comfort in floating rate interest funds. These are the debt funds with predominantly securities linked to floating rate instruments (yields of these change with the change in the benchmark rates) and the rest in debt instruments which could be converted to floating rate using Swaps. These 'swap' allows to manage the duration and thus provide a good offset for the changing rates.

The Securities and Exchange Board of India (SEBI) has allowed this category of mutual funds (MF) with a minimum of 65 per cent investment into floating rate instruments with the remaining in other fixed income structures including Overnight Index Swaps (OIS). Since there's a dearth of floating rate instruments in the market, MFs use the derivatives instruments like rate swaps or OIS to convert the fixed coupon portfolio into a floating rate portfolio. The benchmark interest rate is MIBOR (Mumbai Inter-Bank Offer Rate) or the Repo rate with a quoted spread (premium or discount depending upon the liquidity).

In a changing rate scenario, the floating rate funds act dynamically to offset as much as the change. For example, one were to purchase an instrument with a coupon of MIBOR+100 bps (basis points), it's understood that the MIBOR closely tracks the operating rate (i.e. repo rate or reverse repo) and in a scenario where there is a change in repo or reverse repo, say a hike of 25 bps, then MIBOR would also go up by 25 bps. That ensures investor retaining the higher coupon from the floating rate security. This is not the case with a fixed coupon bond or instrument which is immune to the rate changes.

OIS is a hedging contract is where two parties exchange or swap the interest payments on a notional principal. The floating part of the swap is linked to Overnight Index. The parties include the two functions of the contract with one representing to pay the fixed (OIS rate) and the other agreeing to pay the floating rate. These contracts have a notional contract value and doesn't cost for the parties to enter. The overnight MIBOR rates are daily compounded and the end of the periodic reset, the net interest differential is exchanged as the net loss position paying the net gain position. For example, if the overnight MIBOR is greater than fixed OIS rate then the party agreed to pay the floating will be the net payer to the position and vice versa.

While I've elaborated on how these funds operate, the outcome doesn't always be as per our intention and is subjected to market vagaries. The composition of the fund is critical in the risk associated with the fund as the 'fixed' part of the portfolio could be a diversified and thus prone to excessive risk if not properly analyzed. While floating rate funds tend to benefit the most during a raising interest rate period, providing lower volatility relative to their shorter-term cousins, the credit risk is inherent to this part of the portfolio.

Allocation to these funds should be done with a sense of changing interest rate scenario as they could diminish the returns in a reducing interest rate environment. Also the quality of instruments to be considered before making an investment and still could restrict only to a part of the portfolio depending on the risk profile of the investor.

(The author is a co-founder of Wealocity, a wealth management firm and could be reached at [email protected])