Mutual Funds: Why floater funds are showing promise

Floating rate funds invest in AAA-rated instruments.

With interest rates likely to move up, smart investors are investing in floater funds of mutual funds. The assets under management (AUM) in this category have nearly doubled from Rs 32,481 crore in May 2020 to Rs 62,638 crore in January 2021. In fact, while investors pulled out Rs 33,408 crore from debt mutual funds in January, floater funds reported net inflows of Rs 3,128 crore.

Floater funds invest at least 65% of their total assets in floating-rate instruments. These funds benefit from a rising interest rate scenario as the coupons on such instruments are adjusted upwards when interest rates move north. Given the dearth of floating rate instruments in the Indian debt markets, these funds typically invest in fixed-coupon bonds and use derivative instruments such as interest rate swaps to convert the fixed-rate receivables into floating-rate.

Dhaval Kapadia, director, Investment Advisory, Morningstar Investment Adviser (India), says in the recent past, interest rates have moved lower across the yield curve to multi-year lows following sharp rate cuts and other measures by Reserve Bank of India. “Concerns over a roll-back of these support measures leading to a possible upward move in interest rates have increased the attractiveness of the floater funds category. As a result, this category has seen increased traction over the past 6-8 months. The recent Budget announcement of higher government borrowing coupled with rising interest rates across the globe has further exacerbated concerns over a pick-up in interest rates. Hence, the floater funds category may further attract investor interest,” he says.

Returns from funds
Floating rate funds invest in AAA-rated instruments. On average, the category has offered 7.8% returns for one year, 8.48% for two years and 8.19% for three years. In the current scenario, these funds can generate good returns in the near term.

Harshad Chetanwala, co-founder, MyWealthGrowth, says traditionally, whenever interest rate rises, return on floater funds also goes up as the funds predominantly invest in floating rate instruments. “As the interest rates are expected to increase gradually in coming quarters, the benefit of increasing interest rate will also pass on to the floater funds,” he says.

What to look out for
As floater funds are a new category—there are eight funds at present— and the AUM in this category is mostly dominated by corporates and HNIs, retail investors must understand the default or credit risk.

Brijesh Damodaran, managing partner, BellWether Advisors LLP, says when investing in debt schemes, be it liquid, floater, duration or accrual funds, one must look at the portfolio constitution and the risk associated in it. “With increasing yields, the returns on the shorter end of the curve are going to be low,” he says.

Floater funds are highly sensitive towards interest rate and hence the returns will fluctuate as and when interest rate changes.

Chetanwala says the return from floater funds are expected to go along with the interest rate. “Along with that investors should look at the portfolio of the fund and check the quality of holdings before investing. Like every debt fund except gilt funds, even floater funds can invest in debt instruments of private institutions along with the government. Hence floater funds do carry default or credit risk,” he notes.