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Nowhere to invest: why floating rate funds sank

Nowhere to invest: why floating rate funds sank
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First Published: Tue, Jan 05 2010. 10 01 PM IST

Updated: Tue, Jan 05 2010. 10 01 PM IST
If you invest in a floating rate fund, where do you expect it to deploy your money? Perhaps, in floating instruments? In reality, if you glance through floating rate funds, you’ll notice that most of them have not been investing in floating rate instruments. With a dearth of floating rate instruments in the market today, these funds have been forced to reinvent themselves and adopt alternative strategies. While that may be a necessary survival tactic for these funds, should you invest in them?
What is it?
Typically, a debt paper is one that is issued by a borrower to a lender and carries a fixed interest rate and tenure, just like a loan. Throughout the tenure, the borrower keeps paying a certain amount of interest to the lender. When the tenure ends, the borrower pays back the principal amount.
Similarly, there are debt instruments that carry a floating interest rate. In other words, instead of paying a fixed interest rate to the lender, the borrower pays a higher interest rate when rates rise and vice-versa. At the end of the tenure, the borrower pays back the principal, just like any other debt instrument.
A floating rate debt fund invests in precisely these types of debt papers, where the underlying interest rate keeps moving—up or down.
Franklin Templeton Asset Management India Pvt. Ltd was the first fund house to launch a floating rate fund in February 2002. Ironically, it did so at a time when interest rates had just started falling, a move that would benefit fixed rate funds. Interest rates and prices of debt papers share an inverse relationship.
Say, there is a debt paper in the market carrying an interest rate of 8%. When interest rates in the economy rise, there will be newer debt papers that will offer the prevailing market rate, say, 10%. Those in the market to lend money would naturally want to lend their money to debt papers that offer 10% interest, as against 8%. As a result, the 8% debt paper loses its value and, therefore, its price falls. Hence, when interest rates rise, price of debt papers fall and vice-versa. In other words, a falling interest rate regime bodes well for long-term bond funds, but a rising interest rate regime, typically, isn’t good news.
On the other hand, liquid funds carried negligible interest rate risk since they invested in very short-term debt papers, but could not offer decent returns, unlike, say, long-term bond funds. Here’s where Templeton launched its floating rate fund to fill the gap. Since the underlying interest rate of floating rate instruments moves up or down, its price does not move correspondingly. In theory, this reduces interest rate risk, and at the same time offers a higher income than liquid funds.
No floats out there
A total of 14 floating rate funds were launched in 2002 and 2003. Apart from providing an asset class to diversify into, floating rate funds didn’t take off well. Between 2003 and 2005, when interest rates fell (and prices of debt securities rose), floating rate funds returned 5.20% as against 5.43% by fixed-income bond funds.
There was a bigger problem, though. Floating rate instruments depleted and these funds could not find enough such papers to invest into. Says Ritesh Jain, head (fixed income), Canara Robeco Asset Management Co. Ltd: “There were no floating rate instruments in the market for these funds to invest in. As a result, floating rate funds, as a name, lost their relevance.”
Alternative strategies
In the absence of true floating rate debt papers, floating rate funds went for alternatives. They invested their corpus in different instruments maturing across tenures. For instance, funds invested a certain portion of their corpus in securities that mature before three months, some that mature before six months, some that mature before nine months and so on. As a result, at different points in time, some portion of their corpus would get reinvested in a fresh set of debt papers at the prevailing interest rates.
Additionally, fund managers also invest in short-term money market instruments. “Most offer documents of floating rate funds are open enough to allow them to invest in instruments that mature overnight,” says Lakshmi Iyer, head (fixed income), Kotak Mahindra Asset Management Co. Ltd
Fund managers also enter into swaps in the debt market to convert their fixed interest instruments into floating instruments. For instance, if a fund manager holds a fixed yielding instrument and expects interest rates to rise, he swaps his fixed income instrument with a floating rate debt paper to hedge the portfolio and also to earn a small returns kicker. However, this is a risky move and requires your fund manager to correctly predict the future interest rate scenario based on which they enter into agreements.
“If your fund manager’s call on the interest rate scenario goes wrong, you lose money,” says a fund manager on conditions of anonymity. For much part of the portfolio though, floating rate funds invest in certificates of deposits, short-term fixed deposits issued by banks and treasury bills, much like many other funds with a short tenure.
Ultimately, fund sources claim, floating rate funds are no longer sold as pure floating rate funds. Most of them are sold as a cross-over between an ultra short-term fund and a short-term fund. Chaitanya Pande, co-head (fixed income), ICICI Prudential Asset Management Co. Ltd, says: “The definition of a liquid fund is fixed by the capital market regulator. However, ultra short-term funds (erstwhile liquid plus schemes) have no fixed definition and their average maturities can sway between three months to a year. Here’s where most of the floating rate funds get slotted.”
What should you do?
Floating rate funds have lost their relevance for the time being. Unless corporates issue floating rate instruments that funds can subscribe to, these funds do not play in instruments that other short-term funds cannot or do not.
In other words, there’s hardly anything special that a floating rate fund offers. Ultra short-term and short-term funds are alternatives that offer better clarity in terms of their investment objectives. Unless your advisor can clearly spell out the uniqueness in a floating rate fund that he offers you, stick to the alternatives.
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First Published: Tue, Jan 05 2010. 10 01 PM IST