What are floating rate debt funds?

Kavya Balaji   /   November 5, 2020
floating rate debt funds

Heard of floating rate funds? These are funds that invest in financial securities which pay a variable or floating interest rate. So, the interest payments for the securities will not be fixed. These are called floating rate debt securities. The interest payments for these will fluctuate as per the prevailing interest rates.

The interest rate for the floating rate security will be based on a particular interest rate benchmark. There are many benchmarks used for floating rate securities. One of them is the MIBOR (Mumbai Interbank Offered Rate). The interest rate for the floating rate security that uses this benchmark will be the MIBOR rate plus a margin. So, every time the benchmark rate changes, the interest rate for the floating rate security is adjusted.

Floating rate funds or floater funds not only invest in floating rate securities, they could invest in preferred shares, corporate bonds, and floating rate loans of less than five years too. According to the Securities Exchange Board of India (SEBI) guidelines, floater funds are open-ended debt schemes that mostly invest in floating rate securities. The minimum investment in these securities needs to be 65% of the total assets managed by the funds.

Two of the top performing floater funds has given double-digit returns in the last one year. The topper in the list of floater funds, Nippon India Floating Rate, has provided investors with 10.9% in one year while Kotak Floating Rate Fund has given 10.5%. Here’s how floater funds have fared: the floater funds category has provided an average return of 8.73% in one year and 7.76% in the past three years. That’s the reason why debt mutual fund investors are interested in the floater fund category. Here are the details you need.

Types of floater funds

There are two common types of floating rate funds. One is short-term floater fund and the other is long-term floater fund. Short-term funds provide better liquidity to investors by investing in securities that have shorter duration.

How to invest in floater funds

You must choose floater funds that are right for your risk profile. These funds come with varying levels of risk across the credit quality spectrum. High yield funds might have lower credit quality investments and higher risks.

Advantages of floating rate funds

Floating rate funds provide investors with a higher interest income in a rising interest rate environment. As interest rates rise, the return from the floating rate funds increase. So, these funds appeal to investors when interest rates are set to start rising.

However, the best advantage with floating rate funds is that they are not highly impacted by interest rate changes. Debt funds that invest in fixed rate securities come with interest rate risks. Interest rate risk is the potential for investment losses because of changes in interest rates. So, debt funds that invest in fixed income securities are volatile and are impacted by interest rate changes. Floating rate funds come with a low degree of sensitivity to changes in interest rates.

Another point is that floating rate funds have very less duration risk. This is the risk of missing out on higher interest rates available in the debt market when interest rates rise. Since floating rate funds provide interest rates that rise with interest rates in the country, there is minimal duration risk.

Apart from the advantage of getting present interest rates and the lower sensitivity to interest rate changes, a floating rate fund helps you diversify your debt investments. Most of the time, investors hold only fixed income investments such as bonds and bank fixed deposits. Adding floating rate funds will provide diversification to the debt part of the portfolio. Another benefit is the affordability. Buying floating rate securities as a retail investor will involve higher costs and more capital. A floating rate fund will help you diversify your funds at a low cost and with a lower capital.

What about the credit risk of floating rate funds? Credit quality of these funds is more or less similar to that of liquid funds and ultra-short-term funds. So, one could say that they are safer than a credit risk fund or a dynamic bond fund.

You can get income from floater funds. These funds declare dividends that could be quarterly, semi-annual or annual. So, you get income and capital gains.

How are the funds taxed?

The taxation will be just as any other debt fund. If you hold the fund for less than three years, you pay short term capital gains. Long term capital gains and indexation benefit will be available oif you stay invested for three or more years.

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