In this episode of ‘Mutual Fund Corner’, R Sivakumar, Head of Fixed Income at Axis Mutual Fund and Raghav Iyengar, Chief Business Officer at Axis AMC discussed all about floating rate funds.
Floating rate funds or floater funds are basically a set of schemes that have a very unique characteristic -- which is that the interest rate or coupon is not pre-decided - it fluctuates or floats.
On how these floaters work, Raghav Iyengar said, “Essentially when you buy a set of debt securities, the coupon or the interest rate is fixed. So if you buy an Axis Bond at 6 percent, you know that your Rs 100 after one year will become Rs 106. In the case of floating rate funds, the coupon is not fixed. It is linked to something maybe an underlying instrument, and as that underlying instrument moves, your interest rates also tend to fluctuate."
"Typically, there is an instrument called the Mumbai Inter-Bank Offered Rate (MIBOR) and let us say that MIBOR is at 4 and I have got a bond at say 50 basis points over MIBOR. If MIBOR goes from 4 to 4.5, my interest rate will also move from 4.50 to 5. So that way, it is a great product for a volatile interest rate environment, especially when interest rates are looking to head higher. It sort of protects the investor from fluctuations in interest rates," he said.
On what makes the floater funds the best bet, Sivakumar said, “In a normal situation, the accepted wisdom is that rising interest rates lead to what's called mark to market losses on bonds. Fixed-Rate bonds depreciate in value when interest rates move up. But a floating rate bond as Raghav just explained, the interest rate of the bond itself rises with rising interest rates scenario. It goes very differently from normal bonds."
"Also, what we see is that similar like maturity, short duration, bonds versus floating rate instruments, we do expect floating rates to outperform in a rising interest rate environment," he said.
On portfolio addition, Iyengar said, “It can be part of the all seasons largely because I think the biggest question investors asked us, especially when times like now is that - what do I do when rates go up or interest rates are going down. So it gives a much better investor experience. I think it is a core part of the allocation. You can do a lot of things with this. I think the floating rate bond market is really getting mature over a period of time and that is a good thing also. So, it should be a part of an investor's core holding.”
Sivakumar added, “I think floating rate funds solve two needs of investors. One is on the liquidity or the cash side. So, instead of holding liquid funds or money market funds, floating rates replace very quickly through the maturity of the bonds. A floating rate behaves somewhere like that because it is linked to a money market benchmark usually and therefore, it could be an easy allocation within the cash allocation of an investor where they can look at this as a slightly higher-yielding cash product.”
“The other is complementing longer duration bonds. As I mentioned earlier, long-duration bond funds typically underperform when rates are going up, and floating rate funds do well when rates are going up. Conversely, when rates are falling, longer duration bonds outperform. So, when you are looking at diversifying your interest rate risk, one option is to, of course, add floating rates in addition to your long-duration bond holdings, so that the duration risk is neutralized or at least reduced," he said.
For entire discussion, watch the video.