Floating rate funds have seen huge inflows in recent months as investors expect interest rates to rise. This is because variable rate funds benefit from rising interest rates unlike other categories of debt mutual funds. Mint explains.
Why are variable rate funds gaining ground?
Investors generally feel that interest rates in the country have bottomed out and are expected to rise in the future. When interest rates rise, bond prices fall. When bond prices fall, the debt funds that hold them take a hit as well. The higher the sensitivity of the debt fund in question to interest rates, the greater the decline in its value. However, floating rate funds buy bonds whose interest rates change according to changes in rates in the economy. This characteristic is therefore supposed to insulate them from losses due to rate hikes and may even increase their returns when rates rise.
How do variable rate funds work?
Floating rate funds work in two ways. First, they buy floating rate bonds. These bonds have interest payments compared to external benchmarks such as the Reserve Bank of India (RBI) repo rate or the yield on three-month Treasury bills. When these benchmarks increase, the bond’s interest rate also increases. 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 to generate returns is to invest in low-quality, short-lived paper. These debt securities tend to have higher yields than their higher rated counterparts.
How do interest rate swaps work?
Interest rate swaps convert fixed rate bonds into floating rate bonds. The fund undertakes to pay the bank the fixed rate it obtains on its bonds in exchange for a variable rate linked to a benchmark index. The bank could agree to pay the Mumbai Interbank Offered Rate plus 3% in exchange for fixed interest rate payments from the fund’s bonds.
What are the problems with such funds?
Floating rate funds have a certain degree of vulnerability to rising interest rates. According to the rules of the Securities and Exchange Board of India, only 65% of the body of floating rate funds must be invested in floating rate instruments. The fund may invest the remaining 35% in ordinary fixed rate bonds, which suffer losses when interest rates rise. Alternatively, the risk may arise from interest rate swaps which do not fully offset the decline in the value of the fund’s fixed rate bonds. Floating rate funds tend to be more adventurous with credit.
Are there alternatives to variable rate funds?
An easier way to guard against interest rate risk is to invest in low-term programs. Categories such as liquid funds, ultra-short bond funds, money market funds and low duration funds have relatively low risk to interest rate hikes because the maturity of their holdings is low. and they are quickly able to buy new bonds with higher interest rates. . You can also split the money between these categories and higher maturity categories to cover your bets, if you are not convinced that the rates will go up.
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