Let us understand the concept of floating rate funds and find out if it makes sense for your clients.
Yields across duration and debt instruments have been moving up over the past couple of months. In the near future, yields are likely to remain stable or move up a bit.
In this backdrop, many fund houses and distributors have been promoting floating rate funds to benefit from RBI’s move to hike rate or suck out excess liquidity. The notion is, as and when RBI tightens policy, the interest rate resets in underlying portfolio will happen at a higher rate and the fund will benefit.
Theoretically, this notion is not wrong but we should first understand how a floating rate bond fund works. The purpose of this article is not to de-sell the concept of floating rate funds but to put things in right perspective so that it leads to right selling and fits properly with the investment objectives of investors.
What is a floating rate bond?
In a regular conventional bond, coupon rate is fixed and defined e.g. in a 7% coupon bond, an issuer pays interest at 7% every year. In a floating rate bond, this coupon rate is not fixed. In these bonds, there would be a benchmark, say MIBOR (Mumbai Inter-Bank Offer Rate) and there would be a mark-up, say 1%. If payout frequency were say annual then the average MIBOR of the last one year is the reference point and the coupon rate would be average MIBOR of last one year plus 1%. If MIBOR rate adjusted to 6.5%, the coupon rate in floating rate bonds would be 7.5% (6.5%+1%).
The notion is a floating rate bond fund invests in floating rate bonds and as and when the interest rate moves up, in this case the MIBOR rate, the new adjusted rate is higher and you get a higher interest.
Issues and concepts
The key challenge in floating rate bonds is lack of availability. As on 30 June 2020, of the total outstanding stock of Rs.33.20 lakh crore of corporate bonds, quantum of floating rate bonds was only Rs.1.28 lakh crore i.e. less than 4%. In this situation, it is difficult for a fund manager to construct a portfolio comprising floating rate bonds. SEBI norms say that for a fund to be eligible under any category, minimum 65% of the portfolio should satisfy that description.
To overcome this challenge, fund managers invest in what is colloquially knows as ‘synthetic floaters’. There is a market called Overnight Indexed Swap (OIS) where interest rate of fixed and floating are swapped.
One party to this transaction agrees to give a fixed coupon on an instrument to a counterparty, and other party gives floating rate linked to a benchmark e.g. MIBOR. It is difference in views that is traded. When a fund manager swaps fixed coupon on an instrument in the OIS market, the instrument remains in the portfolio. It is a notional trade where the coupon (or part of the coupon) on a fixed rate instrument is swapped for floating rate.
Combining both floating rate bonds in portfolio and synthetic floaters, fund managers satisfy the 65% criterion.
The issue is dynamics of the two markets i.e. the regular bond market as we know and the overnight/OIS market are different. Since floating rate fund holds fixed rate instruments in its portfolio, it is subject to mark-to-market (MTM) changes. That is, when bond yield in the secondary market moves up and prices come down.
Floating rate funds benefit only if RBI hikes rates or sucks out excess liquidity from the system as these factors can lead MIBOR to move up its interest rate.
However, if RBI maintains its stance to support growth by not hiking rates and keeping adequate liquidity in the system, floating rate bonds can underperform all other categories.
A case in point, over the last couple of months, when the money market and bond market has been volatile i.e. yields have been moving up, floating rate bond funds have underperformed liquid funds, ultra short funds and money market funds.
The point here is it is not one-to-one correspondence between yields in the secondary market moving up and the benefit visible in floater funds.
Financial products are comparable to medicine; medicines are good if it is prescribed with a proper diagnosis of patients. Floating rate funds need to be understood and every AMC has a unique strategy for the fund, which needs to be understood by the advisor/distributor. Remember that you should not position these funds solely on expectation of rate hike by RBI.