A floating rate fund is the one that invests in financial instruments that offer a floating rate of interest. These funds invest in those debt instruments and bonds which offer fluctuating interest rates. These can include corporate bonds and other fixed income instruments. Since the bond market in India is not huge, these funds tend to include derivative instruments to meet the SEBI mandate that requires these funds to invest at least 65 percent of assets in floating interest instruments.
How it works
There could be several investments that comprise a floating rate fund which include stock, corporate bonds, and loans.
One of the key advantages of a floating rate fund is that it is least responsive to the interest rate changes when compared with a fixed income instrument. In fact, floating rate funds become attractive among investors when interest rates are rising because of the higher income they offer.
Aside from lower sensitivity to changes in interest rates, a floating rate fund allows an investor to diversify fixed income instruments. More often than not, fixed income instruments include bonds. So, a floating rate fund offers a degree of diversification to a fixed income portfolio.
Since floating rate funds offer fluctuating interest rates, these funds are less susceptible to duration risk. It is a risk of missing out on higher interest rates while an investor holds fixed interest debt instruments.
Constituent securities
While zeroing in on a fluctuating rate fund, the investor must evaluate the risk level of constituent securities. Since lower credit quality investments carry a higher risk, funds with a higher interest rate are likely to carry a bigger risk. Similarly, the funds with lower interest rates might be less risky in comparison.
As per SEBI guidelines, a floating rate fund is an open-ended debt fund that invests a minimum of 65 percent of assets in floating rate instruments.
But since the Indian bond market is not huge, the floating rate funds rely on derivative instruments such as interest rate swaps including OIS (overnight index swaps) to convert fixed interest portfolios into floating rate.
Overnight index swap is a contract between two parties where they exchange the interest payments on a principal amount. In these contracts, one party agrees to pay fixed interest while the other agrees to pay floating rate on a notional principal amount.
Floating rate funds entail debt instruments whose interest rate varies according to prevailing interest rates in the market. Though conceptually they are high income yielding funds, their limited availability can prove to be dampener for the keen investors.