Franklin Templeton is launching Templeton Floating Rate Income Fund (TFRIF). This innovative bond fund will invest 65 percent in debt instruments carrying a variable interest rate and the balance in fixed income instruments. TFRIF comes in two flavours a short-term plan, for investors with investment duration of 1-6 months and the long-term plan. Unlike standard debt instruments, which bear a fixed coupon for its entire term, the interest on a floating rate bond is revised periodically. The resetting is done by marking up a fixed percentage on the ruling interest rates (yields) on the chosen debt instrument or a benchmark. For instance, a floating rate bond (FRB) with 50 basis points spread over the lending rate of banks will earn 7 per cent till any revision in the bank rate.
This periodic realigning of the coupon with the changing interest rates makes floating rate bonds relatively more stable as compared to the fixed income instruments which give fixed interest in their full tenure irrespective of changes in interest rates. Hence, a fund dominantly invested in floating rate bonds should be less volatile. However, managing the fund will be to tough given the limited and less liquid market of floating rate bonds. And to overcome this constraint, the fund will have to invest in interest rate swaps which comes at a cost.
No doubt bond have been hugely rewarding in recent times but they were volatile too. And on special situations of extreme uncertainty they almost behaved like equities. If you don't like the wild ride of a bond fund, floating rate bond fund could be suited for you. But it is likely to earn little less than a bond fund for the stability it comes with. And it should deliver superior returns over a cash fund, which maintain short duration of their portfolio for stability at the cost of lower return.
When interest rates go up, then bond go down in value and so does a bond fund. But a floating rate bond fund will escape the sharp fall on such instances. On the flip side, if interest go down, bonds and bond funds gain in value. This is how they earned hefty returns through 2001. On such instances, a floating rate bond fund will not benefit much.