What are floating rate funds?

Floating rate funds are a category of fixed-income mutual funds that invest primarily in debt instruments with floating interest rates. Unlike traditional fixed-income securities, where interest rates remain constant over the investment period, the interest rate in floating-rate instruments is reset periodically based on a benchmark, such as the repo rate. This helps mitigate some of the risks associated with fixed-income investments.

Table of contents

What Is a Floating Rate Fund?
Features of Floating Rate Funds
How Does Floater Fund Work?
How Should You Invest in a Floater Fund?
Factors to Consider Before Investing in Floating Rate Funds
Why Should You Invest in a Floater Fund?
Taxation Rules of Floater Fund

What is a Floating Rate Fund?

A floating rate fund is a debt mutual fund that primarily invests in securities with interest rates that adjust periodically based on a benchmark, such as the Reserve Bank of India's (RBI) repo rate. Unlike fixed-rate bonds, these instruments offer interest payments that fluctuate in response to changes in the benchmark rate. Floating rate funds seek to provide returns that adjust in line with changes in market interest rates.

These funds aim to reduce the impact of interest rate fluctuations.

Features of Floating Rate Funds

Understanding the key features of floating rate funds can help investors assess whether they align with their financial goals and risk tolerance. Some of the key features are mentioned below:

According to the definition of floating rate funds and its categorisation by SEBI, such a fund must invest 65% of its assets in floating rate instruments. Such funds combine the potential stability of fixed-income securities with the flexibility to adapt to changing interest rate environments. Here are some of their features:

Dynamic interest rate: Bond prices in the market are inversely proportionate to the interest rate, which is what contributes to the risks involved in debt investments. The variable interest rate of the securities included in floating rate funds can make them relatively resilient to interest rate fluctuations.
As interest rates rise in the economy, the coupon rates of floating rate securities increase. This can mitigate the impact of rising interest rates on the fund's Net Asset Value (NAV).
Portfolio diversification: Maintaining a diversified portfolio is a key investment strategy with floating rate funds, meaning that they invest in floating rate bonds, floating rate notes, treasury bills, and other money market instruments.
Lower interest rate risk: Floating rate funds are less vulnerable to interest rate risk compared to traditional fixed-income funds. Since the coupon rates of floating rate securities reset periodically, the principal value of the fund's investments is less sensitive to changes in interest rates.
Income generation: They offer potential income generation opportunities for investors through regular coupon payments received from the underlying floating rate securities.

How does Floater Fund work?

Floater funds invest in debt securities with interest rates that reset periodically based on a benchmark. As the benchmark rate rises, the interest paid on these securities also increases, and if it falls, the interest payments decline.

The fund manager allocates capital to instruments such as floating rate bonds, treasury bills, and other variable-rate debt securities.
The fund’s returns depend on movements in the benchmark interest rate.
When interest rates increase, the potential returns from these funds may also rise.
Conversely, a decline in interest rates can result in lower potential returns.

The performance of a floater fund is directly influenced by changes in prevailing interest rates in the Indian financial market.

How should you invest in a floater fund?

Investing in a floater fund should align with your financial objectives and ability to tolerate interest rate fluctuations. It's important to evaluate your investment timeline and the potential effects of changing interest rates. Here are some considerations:

Assess your risk tolerance, as these funds are influenced by interest rate movements.
Review the fund’s expense ratio and past performance*.
*Past performance may or may not be sustained in future.
Diversify your investments by allocating a portion to floater funds rather than concentrating your entire portfolio in them.
Keep track of prevailing interest rate trends and how they may impact returns.
Seek guidance from a financial advisor to determine if a floater fund fits your financial strategy.
Floater funds should be viewed as a component of a diversified portfolio rather than a standalone investment.

Factors to Consider Before Investing in Floating Rate Funds

Now that you know what floating rate funds are, you may be wondering if they are suitable for you. Here are a few factors you must keep in mind:

Interest rate environment: Investors should assess the prevailing interest rate environment and macroeconomic conditions to determine the suitability of floating rate funds in their investment portfolios. Floating rate funds may underperform in a declining interest rate environment.
Credit risk: Although floating rate funds primarily invest in high-quality, short-duration securities, they are not immune to credit risk. Investors should evaluate the credit quality of the underlying portfolio holdings to mitigate credit risk exposure.
Investment horizon: Investors should align their investment horizon with the duration and maturity profile of floating rate funds. Investors with short-term investment horizons may prefer funds with greater liquidity and lower duration.

Why should you invest in a floater fund?

Floater funds may be considered by investors looking to potentially reduce the impact of rising interest rates. Since the returns on these funds adjust with interest rates, they can offer some level of protection against rate fluctuations.

These funds have the potential to generate returns that align with prevailing interest rates.
They may serve as a hedge against rising interest rates.
They provide access to debt instruments with variable interest rates.
They can complement a well-diversified investment strategy.

However, investors should keep in mind that when interest rates decline, the potential returns from floater funds can also decrease.

Taxation Rules of Floater Fund

The taxation of floater funds in India follows the regulations applicable to debt mutual funds. Gains from floater funds are taxed at the applicable income tax slab rate of the investor. Indexation benefits on long-term capital gains are no longer available.

Conclusion

Floating rate funds, which invest predominantly in fixed-income instruments with a variable interest rate, can help mitigate some of the risks associated with the debt market. However, investors should consider the current interest rate environment and their investment horizon before choosing a scheme. It is advisable to consult a financial advisor before making investment decisions.

FAQs

What is a floating rate fund, and how does it work?

A floating rate fund invests in debt instruments with interest rates that periodically adjust based on a benchmark rate, such as the RBI's repo rate. As the benchmark rate changes, the fund's yield also fluctuates. This allows for potential income that aligns with prevailing market interest rates.

How do floating rate funds differ from other fixed-income funds?

The key distinction lies in their interest rate structure. Fixed-income funds provide interest at a predetermined rate, offering relatively steady return potential, whereas floating rate funds have interest rates that change with market movements. This can be beneficial when interest rates rise, but can also reduce their interest income potential when interest rates fall.

What are the benefits of investing in floating rate funds?

Floating rate funds may be beneficial when interest rates rise, as their yields could increase, potentially helping to counteract inflation. They offer the potential for income that adjusts over time, unlike fixed-income funds with a set coupon rate. However, investors should be aware that these funds still carry risk.

What risks are associated with floating rate funds?

While floating rate funds can potentially adjust to rising interest rates, they also come with risks. They are subject to credit risk, where the issuer may default, and if interest rates decline, the fund's yield could decrease. These funds also face liquidity risks and the possibility that benchmark rates may not move as expected.

Who should consider investing in floating rate funds?

Investors looking to potentially reduce the impact of rising interest rates on their debt portfolio may consider floating rate funds. These funds can be suitable for those with a moderate risk appetite seeking potential income adjustments based on market rate changes. However, it is important to account for the credit and liquidity risks involved.

How do floating rate mutual funds generate income?

Floating rate mutual funds generate potential income by investing in debt instruments with interest rates that reset periodically based on a benchmark rate. As the benchmark rate fluctuates, the interest earned by the fund also varies, leading to potential changes in interest income.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.

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Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.

The content herein has been prepared on the basis of publicly available information believed to be reliable. However, Bajaj Finserv Asset Management Ltd. does not guarantee the accuracy of such information, assure its completeness or warrant such information will not be changed. The tax information (if any) in this article is based on current laws and is subject to change. Please consult a tax professional or refer to the latest regulations for up-to-date information.