Floater Funds
According to SEBI, a floater fund is a type of mutual fund that must invest at least 65% of its total assets in floating rate instruments. These are debt securities whose interest rates reset periodically based on benchmark rates such as the RBI’s repo rate. The objective is to protect investors from interest rate risk as the returns dynamically adjust with market interest rate changes.
Floater funds are a type of debt mutual fund that primarily invest in floating-rate bonds and securities. These bonds have interest rates that periodically reset or adjust according to prevailing market interest rates, typically benchmark indices. This characteristic helps floater funds manage interest rate risk, as their returns tend to fluctuate in accordance with changing interest rates in the economy.
Key Features of Floater Funds:
- Minimum 65% allocation in floating rate instruments: The fund must invest at least 65% of its assets in floating rate debt instruments. These include floating rate bonds or fixed rate bonds converted to floating rate through swaps. This ensures the portfolio interest rates reset periodically based on benchmark rates like the RBI repo rate.
- Investment flexibility: The remaining up to 35% can be invested in other debt and money market instruments, including short-term deposits, commercial papers, certificates of deposit, and units issued by REITs or InvITs (typically with prescribed limits).
- Credit quality and maturity norms: Fund managers must adhere to credit rating standards and maturity limits as per SEBI regulations to maintain portfolio quality and risk controls.
- Risk management: These funds balance credit risk and interest rate risk, with floating rates protecting investors from rising interest rate scenarios as the coupon resets with market rates.
- Open-ended structure: Floater funds are generally open-ended, allowing investors to enter or exit the fund at any time.
- Suitable for moderate risk investors: They are less sensitive to interest rate changes than fixed-rate debt funds but still carry some credit risk.
- Returns linked to interest rate movements: The returns on floater funds tend to increase when interest rates rise and moderate when rates fall, providing a hedge against interest rate fluctuations.
- Potential inclusion of structured obligations and derivatives: Some floater funds may invest a limited portion in structured credit or use derivatives under strict regulatory limits.
How Does Floater Funds Works:
- Investment in floating rate instruments: At least 65% of the fund’s portfolio is invested in floating rate debt securities. These could be corporate bonds, government securities, treasury bills, or money market instruments where the coupon or interest payment resets periodically based on benchmark rates.
- Rate reset mechanism: The interest rates on these instruments reset periodically (e.g., quarterly or semi-annually) according to prevailing market or benchmark rates. When interest rates rise, the coupon payments increase, and when rates fall, the payments decrease, making the returns dynamic and responsive to the interest rate environment.
- Use of derivatives or swaps (if needed): If there aren’t enough floating rate instruments available, fund managers may use interest rate swaps or other derivatives to convert fixed-rate exposures into floating-rate ones, maintaining the fund’s floating-rate characteristic.
- Dynamic portfolio management: Fund managers actively rebalance the portfolio to align with interest rate changes and market conditions, to optimize returns and manage risk.
- Interest rate risk mitigation: Because the interest payments adjust with market rates, floater funds are less sensitive to interest rate fluctuations compared to fixed-rate debt funds, which helps protect the investors’ capital during rising interest rate scenarios.
- Return behavior: Returns tend to increase when interest rates rise and moderate when rates fall, making these funds especially useful in an environment where rates are expected to go up.
Pros and Cons:
Pros:
- Protection from Interest Rate Risk: Floater funds adjust their returns with market interest rates, offering higher returns when rates rise and protecting investors from losses that fixed-rate bonds may face in a rising rate environment.
- Potential for Higher Returns in Rising Rate Scenarios: Since coupons reset periodically based on benchmark rates, these funds benefit from increasing interest rates.
- Liquidity and Flexibility: Most floater funds are open-ended, allowing investors to enter or exit anytime without penalties.
- Regular Income: These funds aim to provide regular income through interest payments linked to floating rate instruments.
- Lower Interest Rate Sensitivity: They are less sensitive to interest rate changes compared to fixed-rate debt funds, reducing volatility related to interest rate movements.
- Diversification: Add a different risk-return profile to a portfolio compared to equities or fixed income funds.
- Moderate Risk Profile: Compared to equities, floater funds carry lower risk, suitable for investors with moderate risk tolerance.
Cons:
- Lower Returns in Stable or Falling Rate Environments: When interest rates are stable or declining, floater funds may underperform fixed-rate debt funds, as their coupons adjust downwards.
- Credit Risk: These funds invest in debt instruments and are exposed to the risk of issuer default or credit downgrades, which can impact returns.
- Market and Liquidity Risk: Market conditions and economic factors can affect fund performance, and some underlying securities may have limited liquidity.
- Limited Capital Appreciation: Unlike fixed-rate funds that may gain in falling interest rate scenarios, floater funds have constrained potential for capital gains as their returns fluctuate with rates.
- Less Popular and Awareness: Floater funds may not be as well-known or widely available, which could limit investor familiarity and accessibility.
