What is floater fund

The repo rate is the rate at which the Reserve Bank of India (RBI) extends credit to commercial banks. This rate matters because it influences how other interest rates in the economy move.

When the repo rate increases, bank borrowing costs rise, which in turn raises loan interest rates. On the other hand, when the repo rate declines, borrowing becomes more affordable and may lead to lower interest rates on loans. Debt funds are directly impacted by these changes since their holdings of bonds and other fixed-income products may lose value due to shifts in interest rates.

Now, imagine a type of fund that adjusts its strategy based on these interest rate changes. Enter the floater debt fund. To know more about floater funds and how they work, keep reading.

Understanding floater fund

Floater debt funds are a specialised category within the broader spectrum of debt funds, designed to mitigate the typical volatility associated with fixed-income investments. Unlike traditional income funds that park money in fixed-rate instruments like bonds and government securities, floater funds, as the name suggests, primarily focus on securities with floating interest rates.

These floating rate instruments adjust their interest payouts in alignment with market rates, typically pegged to benchmarks such as the Mumbai Interbank Offer Rate (MIBOR). The interest rates on these securities are reset at regular intervals, ensuring that the returns closely track the current market conditions.

Following SEBI‘s categorisation, floater funds must allocate at least 65% of their portfolio to floating-rate instruments. This allocation can also include fixed-rate bonds that have been transformed into floating-rate exposures through derivatives or swaps, broadening the fund’s flexibility in managing interest rate risks. 

Types of floater debt funds

• Short-term floater funds focus on investments in debt instruments with limited duration. These include highly liquid instruments such as Treasury Bills (T-bills), Certificates of Deposit (CDs), and government securities. The aim here is to provide investors with stability and quick returns, aligning with short-term market interest rate movements.
• Long-term floater funds, on the other hand, take a broader approach. They diversify their portfolio by investing a significant portion in floating rate instruments, while also allocating funds to fixed-income securities and money market instruments. This mix aims to provide a stable balance of returns and adaptability to changing market rates over a longer period, offering the potential for higher returns.

Benefits of investing in floater funds

For investors looking for steady returns with a lower risk profile, floating rate funds have several benefits. Here’s a breakdown of their benefits:

Mixed portfolio diversification

Floater funds invest in a variety of floating rate instruments alongside a portion in fixed-income securities. This diversification enables investors to potentially gain better returns amidst fluctuating interest rates, providing a balanced approach to income generation.

Potential for higher returns

In situations where interest rates are on the rise, floater funds can offer higher returns than traditional short-term debt funds. Their ability to adjust to interest rate changes makes them less sensitive to short-term market fluctuations, potentially providing investors with lucrative gains over time.

Tax efficiency

Capital gains tax is applied to capital gains from floater funds. For holding periods of less than three years, short-term gains are subject to taxation according to the investor’s income tax bracket. Long-term gains, on the other hand, are taxed at 20% with indexation benefits for investments held for more than three years, offering a tax-efficient way to realise gains.

Lower risk profile

Designed for investors who prefer stability, floater funds present a less risky option by focusing on debt securities. While they exhibit slight volatility and carry credit risk associated with the issuer’s ability to pay interest, careful selection of high-credit-quality securities can mitigate these concerns.

Low cost

In terms of expenses, floating rate funds are relatively cost-effective. They typically feature a lower expense ratio because they don’t bear high transaction costs or hefty management fees. 

Limitations

• Compared to fixed-income funds, floater funds might deliver lower returns, particularly in environments where interest rates are declining or remain stable. This is because their interest earnings adjust with market rates, which can sometimes lead to reduced income.
• Despite their advantages, floater funds are not as prevalent or well-known among Indian investors. The lack of familiarity with these funds’ features and benefits may lead to underutilization, as investors might opt for more traditional or familiar investment options.

 As of September 2023, India’s cumulative outstanding bond value amounted to ₹2,05,26,243.06 crores, with only about ₹74,43,249 crores (~2%) accounted for by float bond instruments. This relatively small percentage highlights the underrepresentation of floater funds in the broader bond market.

Bottomline

Floater debt funds offer a strategic solution for investors looking to mitigate interest rate volatility. They adapt to rising rates, potentially offering steadier returns and presenting a low-risk, cost-effective option. However, their performance may vary in different rate environments, and their relatively low profile could impact investor uptake. 

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