Bond funds have had an excellent run in the falling interest rate environment of the past two years. When interest rates fall existing bonds, which carry higher interest (coupon) become more attractive. Their price thus rises. And it is this rise in bond prices, which has driven the bond fund returns in the past 2 years. Now if interest rates go up, the situation should reverse. Newer bonds/freshly issued bonds will carry a higher coupon. They will thus be more sought after as compared to older bonds. An existing portfolio could see its value fall as its bonds fall in price. A rising interest rate environment could thus be hazardous to bond fund investors.
And that's where a floating rate fund steps in. A floating rate fund consists of floating rate instruments. In normal (non-floating bonds) the price of the bond changes to accommodate changes in the interest rate environment. In floating rate papers the coupon is re-adjusted periodically. Because of this price change is minimal as compared to 'normal' bonds, floating rate bonds are less volatile. A portfolio of floating rate instruments as in a floating rate fund can thus be used as a hedge in times of rising interest rates.
The idea is that returns of a floating rate fund should be close to that of non floating funds with similar maturity, but with a lower volatility. Thus, when interest rates fall, the returns of a floating fund will rise too. But when interest rates move up, a floating rate fund will be the only income fund that protects returns—as their coupon will be set to higher levels.
As it is widely believed that interest rates are now close to bottoming out fund houses have scrambled to launch floating rate funds. This year so far, seven AMCs have launched floating rate funds. In comparison in 2002 there was only one floating rate fund—Templeton India Floating Rate Fund.
It is also not that other income funds cannot protect returns. They could, by lowering their portfolio maturity so that they are not impacted by price change (longer term paper are the most responsive to any change in interest rates). But then this will call for timing the market—always a difficult thing to do and secondly moving away from their investment mandate in terms of maturity and investment horizon.
Hence a floating rate fund can be used to hedge a bond portfolio. However, there is an important caveat. Most medium term bond funds, which are the mainstay of an income fund portfolio have an average maturity of around 6 years. Floating rate funds, even of the long-term variety have a maturity of around 1 year. Clearly the current lot of floating rate funds cannot be an effective hedge for a medium term bond portfolio. It is for this reason that the graph compares a long-term floating rate fund with a short-term debt fund—they both have similar portfolio maturity.
According to fund managers the main reason for this is the absence of sufficient long-term floating rate instruments. However, the government is issuing floating rate papers of longer maturity and this shortage should reduce over time.
And there are alternative instruments available to create the effect of a floating rate instrument. For instance, it is possible to create 'synthetic floaters'. In this, the portfolio consists of short-term instruments that keep maturing at regular intervals and help lock the market-related rate of return at all point in time. Similarly, it is possible to create 'swapped floaters'-which are swapped transactions to convert fixed instruments to floating instruments. These methods are being used by funds to create effective floaters.
In view of the risk control potential of these funds Rajiv Anand, head (investments), Standard Chartered Mutual Fund, says "a floating rate is an ideal investment for a risk-averse investor and for ones who view that interest rates are almost bottoming out." Thus if interest rate is the biggest risk to an income fund, a floating rate fund is the solution.
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