With 6.5-8.5% CAGR in 5 years, floating rate funds emerge as good fixed income option

These debt mutual funds use floating-rate bonds to lower interest rate sensitivity of the NAV; floating rate funds do well when rates are expected to increase and not so well when rate falls

Kumar Shankar Roy Jul 18, 2020

Debt fundsWhen it’s too difficult to keep swimming, then float. That adage may well be true for hapless debt fund investors today. Unsure of which debt funds are suitable to invest in and also wary of interest rate risks, investors are in a dilemma. While a debt fund being good or bad is a matter of subjectivity, there is one rarely-talked about debt fund category that minimises interest rate risk. They are floater funds.

The 7-scheme debt fund club invests a minimum 65% of the total assets in floating rate instruments, which use a variety of strategies to lower interest rate risk and thereby reducing the volatility in returns over the medium term. In the last 5-year period, floater funds have given between 6.5% to 8.5% CAGR, which is quite a reasonable rate of return compared to other debt fund categories. In this article, we throw the spotlight on floater funds.

WTF – What the float

Floating rate instruments provide an avenue to capture uptick in yields. In such instruments, there is a reference index like 1 month or 3 month Mumbai Interbank Offer Rate (MIBOR), and a fixed spread determined at the time of issuance and is based on the market’s perception of the issuer’s credit risk.

Floating rate instruments are issued primarily by corporates. There is a periodic reset of coupons in line with the reference rate (index). The coupon is reset periodically viz. monthly, quarterly or annually. They are from one month to five years maturity.

Also, there are G-Sec floaters and Overnight Index Swap (OIS) that are used in these mutual funds.

Floater funds are open-ended debt schemes predominantly investing in floating rate instruments (including fixed-rate instruments converted to floating rate exposures using swaps/derivatives).

The investment objective of floater funds is to generate reasonable returns and reduce interest rate risk by investing in a portfolio comprising predominantly of floating-rate instruments and fixed-rate instruments swapped for floating rate returns. A scheme may also invest a portion of its net assets in fixed-rate debt securities and money market instruments.

Do note floater funds are positioned to capture yield movement in the 6 months to 12 months segment.

Is volatility really less?

While purely income-oriented debt funds invest in fixed income debt instruments such as bonds, debentures, and government securities, floater funds are a variant of income funds with the primary aim of minimising the volatility of investment returns that is usually associated with an income fund.

For an investor, a floater fund promises steady returns in line with the prevailing market interest rates.

Do floater funds really show low volatility? To understand this, we can use two statistical measures: standard deviation and beta.

The standard deviation is directly proportional to the volatility of the portfolio. In simple terms, a greater standard deviation indicates higher volatility, which means the mutual fund’s performance fluctuated high above the average but also significantly below it. Liquid, overnight, money market, ultra short duration, low duration have a lower standard deviation than most floater funds. So, you can see that floater funds do largely exhibit have lower standard deviation compared to many other categories including banking & psu bond funds, corporate bond funds, short term funds, medium term funds, etc.

Beta is another measure of the volatility of the mutual fund portfolio to the market. Any beta less than 1 denotes lower volatility and higher than 1 denotes more volatility compared to the benchmark. Ultra short, low duration, liquid, and overnight funds typically have lower beta than floater funds. This floater funds exhibit lower volatility compared to many other debt categories. There are a total of 16 debt fund categories.

Returns matrix

Compared to May 2020, June 2020 saw an 8-fold jump in net inflows at over Rs 3,100 crore in floater funds. The net assets of floater funds is around Rs 36,000 crore.

The biggest floater fund is HDFC Floating Rate Debt Fund (Rs 13,693.74 crore), followed by Nippon India Floating Rate Fund (Rs 13,080.24 crore), ICICI Prudential Floating Interest Fund (Rs 7,546.98 crore), Aditya Birla Sun Life Floating Rate Fund (Rs 6,488.27 crore), UTI Floater Fund (Rs 1,683.41 crore), Kotak Floating Rate Fund (Rs 319.72 crore) and Franklin India Floating Rate Fund (Rs 167.05 crore).

Given that there are 7 schemes in floater funds, it is easy to find a return range for floater funds. The 1 year returns of floater funds is between 7% to 11.7%. The 3 year returns of floater funds is between 6.7% CAGR to 8.2% CAGR. The 5 year returns of floater funds is between 6.5% CAGR to 8.5%. The 10 year returns of floater funds is between 6.6% CAGR to 8.9% CAGR.

Floating rate fund returns

Fund Name 1 Yr (%) 3 Yr (%) 5 Yr (%) 10 Yr (%)
Aditya Birla Sun Life Floating Rate Fund 9.48 8.22 8.47 8.90
Franklin India Floating Rate Fund 6.98 6.76 6.49 6.60
HDFC Floating Rate Debt Fund 9.31 8.02 8.19 8.62
ICICI Prudential Floating Interest Fund 9.39 7.65 7.96 8.46
Kotak Floating Rate Fund 10.04
Nippon India Floating Rate Fund 11.66 8.22 8.26 8.56
UTI Floater Fund 8.60

Note: Data not in any particular order

Portfolio scan

The investments as per the rating class say a lot about how a fund invests. Floating rate instruments or others in a debt fund portfolio are rated as per the issuer. Ideally, the credit quality of floater funds should be high quality and average maturity should be short. However, there are no fixed lines here. There are some schemes that construct a portfolio with a maturity of over 3 years and gradually roll-down the duration as they go along. Similarly, there are schemes that have a chunk of below AAA-rated instruments in their portfolio.

As of June 2020 end, HDFC Floating Rate Debt Fund has sovereign exposure of 9.94%. AAA/AAA(SO)/A1+/A1+(SO) & equivalent is 67.3%. AA+ is 2.05% and AA/AA- is 10.56%. A+ and below is 4.05%. Cash and equivalents is 6.1%.

For Nippon India Floating Rate Fund, 100% money is in AAA/SOV/A1+/Cash & Other Receivables. UTI Floater Fund is also another scheme where 100% of the portfolio is invested in AAA, Sovereign & equivalent instruments.

In the case of ICICI Prudential Floating Interest Fund, about 42.5% money is in AAA, 11.8% in Sovereign, 34.3% in AA, 3.1% in A, and 8.3% in TREPS (cash equivalent).

Kotak Floating Rate Fund has nearly 61% money in AAA, AA (CE), AAA (IND), and Sovereign instruments. 24% money is in net current assets. About 15% money is in AA+ segment.

In the case of Franklin India Floating Rate Fund, over 73% money is in ICRA AAA / CRISIL AAA / CRISIL A1+ / SOVEREIGN / (Including Call,cash and other current asset). About 9.6% money is in CARE AA+ and another 10.7% in ICRA AA / CARE AA-. There is also about 6.5% money in ICRA A+.

RupeeIQ take

Floater funds are an alternative to consider for investors looking towards steady returns and liquidity over the near to short term. Besides diversification, These debt funds can help investors looking to augment their returns from other than the conventional fixed income avenues like banks, FDs, post office deposits and bonds, etc.

Some of the floater funds take below AAA-rated exposure with the belief that this provides the fund investors the opportunity to capture high spreads with only marginal exposure. If you see the average maturity of some funds in the plus 3-year category, don’t be alarmed — it is quite likely that those floater funds are taking advantage of steep yield and investing with a 3-year plus horizon.

Related:

NFO: UTI Floater Fund launches to take advantage of rising interest rates


Kumar Shankar Roy

Kumar Shankar Roy is contributing editor with RupeeIQ. Kumar is a financial journalist, with a functional experience of 15 years. He tracks mutual funds, insurance, pension, PMS, fixed income/debt and alternative investments markets closely. He has worked for The Times of India, The Hindu Business Line, Deccan Chronicle Group, DNA, and Value Research, among others, across different cities in India. He is deeply interested in marrying data insights with actionable opinion. He can be contacted at kumarsroy@rupeeiq.com.

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