The Mutual Fund industry has been around for quite some time now, but it has truly mushroomed only around the last decade or so. We have finally begun accepting in one way or another what financial advisors and the Indian cricket team have been saying for a while - Mutual Funds Sahi Hai! While most of us even today associate mutual funds with the stock/equity market (share bazaar as it is fondly known!), debt funds have been witnessing steady growth in India. Debt Funds have come a long way from being a boring one-size-fits-all approach to a customised approach by fulfilling the needs of a variety of investors.

In simple terms, a Debt Fund is a mutual fund which invests in fixed income securities (or many refer to them - bonds/debentures). These securities can be of varying types, including Government Bonds, Corporate Bonds, Commercial Paper, and so on. Debt Funds have typically been used by individuals with a low risk-appetite, whose aim is to preserve their capital, while for investors with a higher risk-appetite, debt funds help achieve an optimal asset allocation. Given that fixed income/debt instruments typically make interest-payments at regular intervals, it has also become a norm for senior citizens to invest in them to protect their capital and provide timely and regular payouts.

This brings us to a very important question - If debt funds are important and in demand, why are investors moving away from debt today? The simple answer lies in the fact that the performance of debt funds is inversely related to interest rates, i.e., whenever interest rates go up, debt funds (in general) perform poorly and vice versa. Does that mean we move away from debt funds when inflation is high and interest rates seem to be rising? The simple answer again would be - No, we can look at floater funds in such scenarios.

Floater Funds are those funds which predominantly invest in floating-rate securities. A floating-rate security is one such financial instrument where the interest payments are linked to a benchmark rate.

Let me explain with a simple example. If you purchase a GOI bond from the RBI, you are assured a fixed interest rate, say X, which will remain the same through the entire life of the bond, regardless of whether interest rates rise or fall in the economy. Effectively, your interest payments remain constant.

If the same bond is offered to you as a floating-rate instrument, your interest rate is not fixed at X, but is instead linked to a benchmark, Y. The benchmark could be the Repo Rate, Reverse Repo Rate, MIBOR, etc. The point remains that if Y goes up, your interest rate goes up and as a result, you receive higher interest payments, and vice versa.

Floater Funds are extremely useful in the scenarios where interest rates move upwards, especially in times of rising inflation. As interest rates move up, fixed-rate securities remain unchanged, and continue providing fixed interest payments. However, floating-rate securities constantly adjust their interest payments with the upward-rising interest rates in the economy. As a result, in a high-interest rate scenario, floating-rate securities outperform fixed-rate securities. Beyond the performance, floating-rate securities also help diversify an investor’s portfolio, by protecting them against sharp interest-rate hikes in the economy.

In an ideal world, we would constantly churn our debt portfolio with changes in the interest rates, between floating-rate and fixed-rate. However, the real world is not as straightforward and it is not feasible for everyone to track interest rates and monitor portfolios all the time.

So, what would be the next best alternative? Simple. Allot a small percentage of your debt portfolio to Floater Funds especially during times of a rising interest rate scenario. In this way, you will be better-off than earning a fixed rate of return. Given the nature of the fund, it is a simple and an effective solution for the present times. So, if you are an investor looking to make a debt allocation, you may consider a floating rate fund

Floater Funds - The Star Performer In A Difficult Debt Market