Due to the health and financial crisis the world is going through for the past 1.5 years, the GDPs are dipping in almost all economies across the globe. To provide liquidity, the Indian government like other governments across the world reduced its base interest rate – Repo rate and didn’t increase it in the last eight sessions. However, now after so many months of uncertainty, economies around the world are expecting a silver lining near the corner and India is nowhere behind. In this kind of market situation, if you are looking for a safe instrument to invest the money that can provide you regular returns as well, then a floating rate fund can be a great option.
What is a Floating Rate Fund?
A floating rate fund is a fund consisted of floating rate investment instruments like floating rate bonds and others. As per SEBI, a floating rate fund has to invest at least 65% of its total AUM in floating rate investment instruments.
While debt investment instruments generally bear a fixed rate of interest or coupon, these floating rate funds are different. They do not have any pre-determined rate of interest or coupon rate.
These funds since invest in floating rate instruments, so the coupon keeps on changing as per the underlying rate of interest/coupon. The underlying interest rate can be the REPO Rate or the interest rate of NSC, MIBOR, and others.
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How does it work?
The interest/coupon of floating rate instruments is decided to depend upon the base rate. For instance, the fund you invested in has a Floating rate savings bond, 2020 in it. The underlying interest/coupon rate of this bond is of a National savings certificate or NSC of 5-years tenure. Now, the interest rate of 5-year NSC is 6.8% at present. This floating rate savings bond, 2020 has promised to pay 35 basis points above the prevailing NSC rate.
So, the coupon for this bond has been fixed at 7.15% for the period of 1st of July, 2021 to 1st of December, 2021 and it is payable on 1st of January, 2022.
This is how the floating rate instruments work and the fund is an aggregate of all the returns provided by the instruments in it. However, there are very few floating rate instruments in the country at present and thus Mutual Funds make use of derivative instruments like Interest Rate Swaps like Overnight Index Swaps to convert the fixed coupon yielding portfolio in to floating rate portfolio. Overnight Index Swap (OIS) is a hedging contract between two parties, wherein the two parties exchange or swap the interest payments on a notional principal amount. The floating leg of the swap is linked to an overnight index.
Why it can be a good investment option in this market situation?
Coming to the recent economic and investment market scenario of the country and also worldwide, markets are opening, businesses are again catching up and demands are increasing. This suggests that the interest rate which was kept low for quite a long duration will again increase shortly as an increase in real GDP also leads to an increase in interest rates. A floating rate fund will provide higher returns if the interest rate goes up in the future. When you invest in a fixed-income fund, even when the rate of interest in the economy increases, you continue to receive the interest/coupons at a lower rate, also this can lead to MTM loss and fall in NAV.
Another benefit of investing in these funds can be the liquidity factor as well. Even though these funds are new and catching up with the market but these invest in money market instruments and they are highly liquid. In a time like this, when everything is so uncertain, investment should be liquid as much as possible. So, if and when needed, you can encash the same. However, one should also note that during favourable conditions fund may also take exposure upto 35% of the total portfolio to low rated papers to generate better returns.
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Floating rate funds are becoming mature and popular amongst investors of all nature and risk appetites as these funds provide a broader ground for diversification. Especially in a time like this, these funds can be beneficial as return/coupon will increase as the interest rate increases in the economy.