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Home >Money >Personal Finance >Behind the growing interest in floating rate funds

Floating rate funds have seen huge inflows in recent months as investors expect interest rates to rise. This is because floating rate funds benefit from rising interest rates unlike other debt mutual fund categories. Mint explains.

Why are floating rate funds gaining traction?

There is a general perception among investors that interest rates in the country have bottomed out and are expected to rise going forward. When interest rates rise, bond prices fall. When bond prices fall, debt funds holding them also take a hit. The higher the sensitivity of the debt fund in question to interest rates, the higher is the fall in its value. However, floating rate funds buy bonds whose interest rates change according to the changing rates in the economy. This feature is thus supposed to insulate them from losses because of rate hikes and can even increase their returns as rates rise.

How do floating rate funds work?

Floating rate funds work in two ways. First, they buy floating rate bonds. These bonds have interest payments benchmarked to external benchmarks such as the Reserve Bank of India’s (RBI’s) repo rate or the three-month treasury bill yield. When these benchmarks move up, the bond’s interest rate also moves up. However, the supply of such bonds is very limited in the market. Second and more commonly, they sign interest rate swaps with banks. A third way in which they generate returns is investing in lower quality paper of short duration. Such debt papers tend to have higher yields than their better-rated counterparts.

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Pre-emptive move

How do interest rate swaps work?

Interest rate swaps convert fixed rate bonds into floating rate ones. The fund agrees to pay the bank the fixed rate it is getting from its bonds in exchange for a floating rate linked to a benchmark. The bank might agree to pay Mumbai Interbank Offered Rate plus 3% in exchange for fixed interest rate payments from the fund’s bonds.

What are the issues with such funds?

Floating rate funds do have some degree of vulnerability to interest rate hikes. According to Securities and Exchange Board of India rules, only 65% of the corpus of floating rate funds has to be invested in floating rate instruments. The fund can invest the balance 35% in regular fixed rate bonds, which suffer losses when interest rates rise. Alternatively, risk can come from interest rate swaps that do not fully compensate for the fall in the value of the fund’s fixed rate bonds. Floating rate funds tend to be more adventurous with credit.

Are there alternatives to floating rate funds?

A more straightforward way to guard against interest rate risk is to invest in schemes with low durations. Categories such as liquid funds, ultra short bond funds, money market funds and low duration funds are relatively low risk when it comes to interest rate hikes as the maturity of their holdings is low and they are quickly able to buy new bonds with higher interest rates. You can also divide money between such categories and higher maturity categories to hedge your bets, if you are not convinced that rates will rise.

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