Floating with the tide

Interest rates are at their rock-bottom levels, owing to the RBI's pro-growth measures in response to the pandemic. But once economic growth is firmly back on track, interest rates will inevitably start rising. Expectations are that it may happen sometime around the turn of the financial year. In anticipation of an increase in interest rates, many investors are flocking to floating-rate funds. In July this year, the category witnessed net inflows of over Rs 7,400 crore, the highest ever since AMFI started declaring its monthly numbers. Over the past one year, the assets managed by the category have grown at the highest rate among other open-end debt categories and more than doubled in this time frame. Four AMCs have launched their floater funds this year, together mobilising about Rs 2,500 crore.

But why? What's driving their popularity? For that, you need to first understand floating-rate funds.

What are floating-rate funds?
As the name suggests, these funds are mandated to invest at least 65 per cent of their assets in floating-rate bonds. Unlike conventional fixed-interest bonds, the interest rate on floating-rate bonds keeps changing in line with the changes in interest rates in the economy.

Bond prices have a negative correlation with interest rates. If interest rates fall, new bonds to be issued will have lower coupons. Thus, existing bonds that carry a higher coupon get more attractive and therefore, their market prices increase. On the flip side, when interest rates rise, existing bonds get less attractive and their prices drop. But since the interest rate of floating-rate bonds itself keeps adjusting, their prices are much less impacted.

This is making these funds popular right now. A rise in interest rates, which is widely expected, will adversely impact other types of bond funds, while floating-rate funds will be somewhat less impacted.

However, it is noteworthy that, unlike the developed markets, floating-rate bonds are fairly limited in supply in India. Fund managers of floating-rate funds have to create them synthetically. They buy fixed-rate bonds and then enter into interest-rate swap agreements (a derivative instrument) to exchange the fixed interest rate on their bond in return for a floating interest rate from the counterparty.

Are they actually better off when interest rates rise?
The short answer is yes. They have demonstrated an ability to cushion the returns when interest rates head north. As depicted in the graph 'Floating-rate funds vs others: 1Y rolling-return', over the last decade, whenever interest rates in the economy (represented by the repo rate in the graph) moved up, floating-rate funds held up well even when other types of bond funds saw a drop in their returns. The longer the maturity of the bond fund, the higher was the fall.

So, should you switch to them now?
Well, you need to be cautious. Kaustubh Gupta, Co-head - Fixed Income, Aditya Birla Sun Life AMC Limited (ABSLAMC), warns against blindly going with the herd. "If you would have asked me sometime in the first quarter of this calendar year, I would have strongly advocated for floater funds. But today, their investment case is somewhat neutral. That's because in the last six months, their spreads have collapsed because of the heavy inflows they have received. I think currently most of the floating-rate papers are trading significantly below the fixed-rate bonds of similar tenure. So, if a two-year NBFC paper is trading at 5 per cent, the rate on a similar floating-rate bond is closer to 4.5 per cent, leaving you with a negative carry of 0.5 per cent. So, rather than joining the craze and investing in any floating-rate fund, look at the duration of the floater fund and be very cautious if the duration or the maturity is very high," he says.

Secondly, the pace of increase in interest rates is widely expected to be fairly moderate, further denting their case. When interest rates start increasing moderately, fixed-interest-rate bonds will witness a small drop in their price. On the other hand, floating-rate funds will be able to cushion this downfall, but the negative carry that they currently have over fixed-interest bonds will offset this advantage. In other words, their prices will fall lesser than conventional bonds but they will also fetch lower accrual income. Both these factors can balance out each other, leaving you with no significant advantage.

Says Gupta, "My view is that the rise in interest rates would be very measured. There are several risks to the growth story due to which it'll be difficult to withdraw the extraordinarily accommodative stance in haste. I believe that policymakers are cognizant of this fact. So according to me, while floating-rate funds make sense, the investment case today is a lot more neutral."