Are floater funds helpful in reducing debt fund risk? Also, what is the ideal investment horizon for such funds?
- Swapnil Mangle
Floating-rate funds mostly invest in floating-rate bonds. While issuing most bonds, the company specifies a coupon depending on the credit quality, i.e., the financial health of that company. So, the company may give you a high rate of return if it is in poor financial health because there's a greater risk of default. On the other hand, if the company is in great financial health, then the coupon or the interest payment will be lower.
However, while issuing floating-rate bonds, the company does not specify the coupon. For instance, it does not say that you will get 9 per cent over the next 10 years. Instead, the company says that the interest rate will be reset every year in line with the changing interest rate. Thus, floating-rate bonds have a variable rate of interest. So, you don't have a long-term guarantee of the interest rate.
So, if today interest rates are low, the floating-rate bonds actually make sense because tomorrow if interest rates go up, then these will be revised upward. But in good times, when interest rates are at a higher level, then these bonds don't make sense because they will also be reset when interest rates get lower. In India, we don't have many floating-rate bonds issued by companies. So, some derivatives are created and fund managers buy those derivatives to create artificial floating-rate bonds. They buy the bonds and derivatives options which change the character of the bonds. It's a complex formula but that is how it is made available. So, floating-rate bonds or floating-rate funds make sense when you are investing at a time when interest rates are low and are expected to rise.
With regard to the ideal investment horizon of such funds, it doesn't matter. Returns from such funds get revised in line with the changing interest rates. All these things, which I am referring to, are talking of the interest-rate risk. The other significant risk of debt funds or investing in bonds is how assured you are of getting your principal back and interest on time. This is called the credit risk, i.e. the likelihood of a company defaulting on its payment to its bondholders. Now, this depends on the credit rating of underlying bonds. So, it entirely depends on the kind of credit these floating-rate funds are taking. Hence, just be careful.
Also, I feel that there are two-three red flags in the design of floating-rate funds. One is that we don't have readily available floating-rate bonds. The other is that it has to be artificially created so it requires a certain transaction and cost. The third is that you will get an interest rate in line with the prevailing interest rates and then mutual funds will have expenses. So, the prevailing interest rate minus expenses will turn out to be the prevailing fixed-income return, nothing more and nothing less. So, don't expect anything dramatic here.
Today, these floating-rate funds have posted some decent returns and investors are getting attracted to them. But they have been in existence for a very long time and I don't think they have any earth-shattering performance for you to really get attracted to them.
