Floating Rate Funds: When Should You Invest in Them?
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Are you looking for an investment option that benefits from rising interest rates in the economy? Do you seek exposure to a fixed income investment that focuses on floating rate instruments? You may consider investing your money in floating rate funds. It is a debt fund that invests at least 65% of its assets in floating rate securities. Moreover, you will find floating rate funds doing well when interest rates are poised to rise in the economy. Should you invest in floating rate funds?

What are floating rate funds?

You have floating rate funds investing in bonds whose interest rates are reset periodically. For instance, you have interest rates fixed for the entire tenure in a regular bond. However, floating rate bonds have interest rates reset periodically to match the interest rates in the economy. 

You have the interest rate of a floating rate bond linked to a benchmark rate such as the repo rate. It is the rate at which India’s Central Bank, RBI, lends money to commercial banks in India. 

As the interest rate on floating rate bonds is linked to a benchmark rate, it is reset at regular intervals in sync with interest rates in the economy. You have floating rate funds investing in these bonds, as they offer higher returns when interest rates are rising in the economy. 

When should you invest in floating rate funds?

According to AMFI data, you have floating rate funds seeing strong inflows during periods of tighter liquidity conditions. For instance, floating rate funds saw high inflows of Rs 9,991 crore for August 2021, which was the highest among debt funds. You may invest in floating rate funds to diversify your portfolio across different types of debt instruments. 

You may invest in floating rate funds when interest rates are expected to rise in the economy. It helps as floating rate funds are linked to benchmark interest rates and can generate higher returns than fixed income instruments when interest rates rise. 

You have fixed interest rate bonds offering lower returns during periods of rising inflation. For instance, inflation, which is the rise in prices of goods and services over time, impacts debt funds that have fixed interest rate bonds in their portfolio. However, floating rate bonds could do well in inflationary conditions, especially if interest rates rise in the economy. 

Things to understand in floating rate funds

You have a duration risk, which is the risk of suffering losses during periods of rising interest rates. It is especially true for debt funds that have bonds of longer duration in their portfolio. However, you have minimum duration risk if you invest in floating rate funds when interest rates rise in the economy. 

You have floating rate funds investing a minimum of 65% of their assets in floating rate instruments. However, they invest the remaining 35% of the assets in bonds that offer a fixed interest rate. It helps if you check the portfolio of the floating rate fund to gauge the credit quality of bonds in their portfolio. Otherwise, you are vulnerable to credit risk if the floating rate fund has lower credit rating bonds in its portfolio. It is the probability of a bond defaulting on its principal and interest payments. 

You must check the AMC and the floating rate fund’s track record over time to gauge their performance before investing your money. It helps if you check the benchmark of the floating rate fund. In a nutshell, you may invest in floating rate funds when interest rates are expected to rise in the economy. 

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For any clarifications/feedback on the topic, please contact the writer at  cleyon.dsouza@cleartax.in

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