The word going around is that the Reserve Bank of India (RBI) is set to normalize (read increase) interest rates. Yes, we are at the cusp of reversal of the interest rate cycle. The common question now is: how to insulate the debt component of the bond portfolio from interest rate hikes (as rates and bond prices move inversely)? Or better still, how to benefit the debt component of the portfolio from rate hikes? The closest solution is to invest in floating rate funds of funds, where the coupon (interest received on defined dates) is expected to move up along with rising interest rates. Due to this expectation, the floating rate fund category is receiving buoyant inflows from investors.
While you can take advantage of floating rate funds, it is important to first understand how these funds work. In other words, understand how your interest “floats” with changing realities.
To do that, we have to understand certain basics. To start with, what is a floating rate bond? It is important to understand this because a floating rate fund is supposed to comprise floating rate bonds. In this, the coupon or interest rate is not defined as a percentage of the face value, which is the case with most bonds. As per the terms of a floating rate bond, there is a defined benchmark, and there is a defined mark-up of interest over the benchmark. In most floating rate bonds, the benchmark is the Mumbai Inter-Bank Offer Rate (MIBOR). This rate captures the prevailing rate in the inter-bank call money market, where banks lend to each other for one day. The rationale is, as and when interest rates move up in the market, inter-bank call rates would move up too, and vice-versa. The mark-up or spread, as it is referred to, is the spread over the reference benchmark.
For illustration, let us say there is a semi-annual coupon payout floating rate bond, bench marked to MIBOR with a spread of 1 per cent. And let’s say the average MIBOR in that six-month period is 3.5 per cent. The coupon for that period will be 4.5 per cent annualized. As per the Securities and Exchange Board of India (Sebi) rules, at least 65 per cent of a floating rate fund should comprise floating rate instruments, so that the interest accrual in the portfolio “floats” along with changing interest rates. However, there is an issue here.
The Floating Segment
Availability of floating rate instruments in India, particularly in the corporate bond segment (i.e., the non-government security or non-G-sec segment) is on the lower side, less than 5 per cent of the outstanding stock. Hence, it is a challenge for fund managers to construct the portfolio amid a dearth of floating rate instruments. The market practice is, to the extent feasible, the fund manager purchases floating rate bonds; for the balance, to make it 65 per cent or more of the portfolio, the manager resorts to another market segment. There is a market called Overnight Indexed Swap (OIS). In this market, participants exchange (called swap) fixed and floating exchange rates.
Let’s take an illustration. A fund manager holds a fixed coupon-bearing instrument, at 6 per cent, in the portfolio. As against this, while the fixed coupon bond remains in the portfolio, he enters into an agreement through the OIS market. Depending on the prevailing rate, let us say the fund manager agrees to pay a fixed rate of 4 per cent and receives the MIBOR rate. On this component, the portfolio receives 6 per cent minus 4 per cent, which is 2 per cent of fixed coupon plus MIBOR. If the MIBOR of that period is 3.35 per cent, then the portfolio accrues at 2 per cent plus 3.35 per cent, which is 5.35 per cent. In market parlance, these are referred to as synthetic floaters because, on the face of it, the portfolio is holding a fixed coupon instrument but it has been effectively converted to a floating one.
Net-net, combining the natural floating rate instruments (MIBOR plus benchmark) and synthetic floaters (OIS swap), 65 per cent or more of the portfolio “floats” with interest rate movement.
Make It Work For You
We started off by saying, nuances of floating rate funds. The nuance is: how does the concept work for you? For floating rate instruments linked to MIBOR, you receive higher rates when inter-bank call rates move up. To be noted, there is a difference between call rates moving up and 10-year G-sec yield moving up. Longer maturity G-sec yields can move up on multiple variables like inflation moving up, expectation of an RBI rate hike, etc. However, call rates move up on actual RBI rate hikes. Hence, it may mean a waiting period for you, when you see 10-year G-sec yield moving up in anticipation, but your floating rate fund compensating you later.
On the synthetic floating component, it may involve a similar waiting period for MIBOR-linked payments. But floating rate instruments bench marked to Treasury Bills (T-Bills) have a shorter response time. T-Bills, though slower than 10-year G-sec to respond in anticipation, are better than call money market.
Another point to note is that for some time, when interest rates are moving up in the market, there may be an adverse impact on the fixed component of the portfolio. The fixed component is 35 per cent (or less) of the portfolio, plus the portion of the synthetic floating component that is based on fixed coupon.
To understand the composition, let us take one fund as an illustration. ICICI Prudential Floating Interest Fund has 51 per cent of the portfolio in natural floating rate instruments, which is predominantly in G-sec (with best credit quality). Of this 51 per cent, 44 per cent is linked to six-month T-Bills, which will react faster in anticipation of rate hikes, and 7 per cent in natural floaters or corporate securities. In the portfolio, 22 per cent is in synthetic floaters, linked to MIBOR. Hence the floating component of the portfolio is 51 per cent plus 22 per cent or 73 per cent, which will earn a higher accrual as and when call money rates and/or T-Bill yields move up. Over the last one year, this fund has outperformed the peer group by virtue of a relatively higher component bench marked to T-Bills than MIBOR.
In conclusion, the category of floating rate debt funds is better placed than other categories of debt funds to insulate you from rising interest rates.