Are floater MFs right for coming rise in rates? | Economic Times

After years of soft interest rates, the cycle is moving towards its next leg—an upward shift in rates. This makes traditional bond funds unattractive. However, fund houses are offering a way out in the form of floater funds. Three new floater funds have been launched this year and another from Axis Mutual Fund is open for subscription. Are these funds the right way to play the coming rate cycle?Traditional bond funds invest in instruments bearing fixed rate of interest. This leaves them vulnerable to interest rate risk. When rates rise, bond prices fall and consequently, bond fund NAVs fall. Floater funds, on the other hand, invest in floating rate bonds that reset coupons at regular intervals. The interest rate is pegged to a reference benchmark rate. A spread is added to the benchmark rate to arrive at the actual coupon rate. With every change in the benchmark rate, the rate offered on the floating rate bond also changes. Since the payout is reset according to prevailing rates, the fund can potentially gain from rising rates. Kirtan Shah, Co-founder and CEO, SRE Wealth, says, “In a rising interest rate scenario, the floating rate bonds will adjust coupons upwards and so the fund will be able to capture higher yields.”Floater funds have managed volatility well to deliver healthy returns 84498661However, there is a dearth of floating rate bonds issued in the bond market—not enough to buy the minimum 65% required to qualify under Sebi norms. To make up for the shortfall, most funds synthetically create such exposures by using interest rate swaps. Basically, fund managers buy fixed rate bonds (mostly government securities and AAA rated corporate bonds) and use overnight index swaps to convert fixed interest exposure into floating. In this arrangement, two parties agree to exchange the difference in the accrued interest as per the fixed and floating interest rates at maturity. While the fund agrees to pay a fixed coupon, the counterparty agrees to pay the floating rate linked to a benchmark. If upon maturity of swap, the floating rate is higher than the fixed, the fund makes a profit on the swap position. This offsets the loss incurred by the fund on the value of fixed coupon bond (due to rise in interest rates). This essentially works as a hedge against interest rate changes and keeps accompanying risks in check.These funds retain the flexibility to invest across the maturity spectrum. There is a lot of variation in the duration profile across these funds. The average portfolio maturity of these funds stretches from as low as 1.06 years to 6.6 years. Clearly, some funds are taking on higher degree of interest rate risk. Vidya Bala, Head – Research, Primeinvestor.in, points out, “Some floater funds run a higher duration that allows them a chance to capture capital appreciation in a softening yield environment.” However, use of interest rate swaps allows the funds to lower effective interest rate risk. The funds’ net duration (sensitivity to interest rate changes) comes down to the extent of the hedge used.Yet, this doesn’t nullify interest rate risk altogether. First, the entire portfolio is not hedged. Floater funds are allowed to park up to 35% of the corpus in traditional fixed rate bonds. The duration built into the fund’s unhedged portion continues to drive mark-to-market volatility. Further, even among floating rate bonds, duration remains in play for the period within two interest rate reset dates. If interest rates move in the interim, it will reflect in the bonds’ mark-to-market value. Besides, a swap agreement on individual bonds may not cover them for the entire tenure. Like a bond maturing after 18 months may be covered with a swap for only 12 months. “A mismatch between the bond’s maturity and the swap term can leave room for duration to creep in,” says R. Sivakumar, Head, Fixed Income, Axis MF.So what can investors expect from a floater fund? Generally, these funds help navigate volatility in the bond market and are suited to a rising yield environment. However, every interest rate or yield uptick may not translate into returns for floater funds. “As reset dates in a portfolio get spread across the year, all bonds may not capture the period of rising yields,” explains Shah. Also, across a portfolio, multiple swap agreements may be signed on different dates and for varying maturities. This can have a bearing on returns.Traditional accrual funds—those generating returns primarily from bond coupons— are also considered a reasonable safeguard against interest rate volatility. Ultra short term bond funds and liquid funds come under this category. These are less vulnerable to capital depreciation even if interest rates rise. Also, since these park money in securities with very short maturity of up to 3-6 months, the portfolio gets refreshed quickly, allowing the fund to capture rising yields in the near term. So is there a need for floater funds? Generally, floater funds can be expected to do a better job, for two reasons. Sivakumar observes, “Floating rate bonds typically enjoy a spread over traditional bonds of comparable duration, fetching higher yields. And while traditional short duration funds rely on reinvestment to capture rising yields, floater funds are configured to automatically benefit.”Investors should hold these funds for at least a year. A shorter time frame does not make sense even when interest rates climb up. The underlying swaps and reset dates may not entirely come in play by the time of your exit, preventing you from benefiting from the higher yield.