- Is it good to invest in floating rate debt funds that invest in securities having a floating interest rate?
- These funds do well in a rising interest rate scenario and vice versa - Read this post to know more
Debt funds invest in debt securities such as corporate bonds, money market instruments, commercial paper, certificate of deposit, treasury bills and government securities. Different types of debt funds invest for varying maturities or duration of these securities. So, there could be a debt fund investing in securities maturing in a day, month, year, three years and more.
Categories of debt funds are classified based on their maturity profile, interest rate strategy and type of securities they buy in the portfolio. Floating rate debt funds or floater funds, as they are called, are a type of debt fund. Let us understand more about these funds.
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What are Floating Rate Debt Funds?
Floating rate debt funds are open-ended debt funds that invest in debt securities that have a floating rate (rate here means the interest rate on that security). These debt securities do not have a fixed rate of interest. This feature makes floating rate funds different from all other debt funds that buy securities having a fixed interest rate.
Let us understand better with an example. Fund A is a floating rate fund while Fund B is some other debt fund. Both Fund A & B buy 10 debt securities in its portfolio today, all with a maturity of 3 years (the entire interest with the principal will be returned to the fund in 3 years).
Let us assume the interest rate on all these securities is 8% today when bought by the fund manager. But a year later, the interest rate offered by these securities increases to 9%. In this case, the floating rate securities in the floating rate fund will switch to giving 9% for the remaining tenure of two years whereas debt securities in Fund B will still offer 8% only.
Thus, returns from floating rate funds change basis the change in interest rates. So, in an environment where interest rates are going up, these funds perform better than other debt funds and vice versa.
The frequency of reset of interest rates is different for all floating rate securities. There will be somewhere where the interest rate is reset after one year, while it could be 18 months for some other securities. Floating rate securities will offer the new interest rate, which is prevalent on the reset date.
Like all other funds, these funds have their own benefits.
Benefits of Investing in Floating Rate Funds
- Returns – You can expect steady returns from these funds when compared to other debt funds since fund returns are aligned to interest rate movement in the financial system. There is no interest rate risk and these funds give better returns in a rising interest rate environment.
- Volatility – Floating rate funds are less volatile as compared to other debt funds which have both interest rate and credit risk.
- Risk – Floating rate funds have low risk as compared to other debt funds. The only risk here is credit risk i.e. the risk of default by the company or borrower. However, if the fund has been rightly selected after analyzing the portfolio, the credit risk will be minimal.
- Liquidity – Floating rate funds provide complete liquidity; these are open-ended funds and you can buy or sell anytime.
- Taxation – If invested for 3 years, once can avail indexation benefits and thus pay lower tax. Debt fund taxation norms apply to these funds, STCG(short term capital gain) tax ( 20% with indexation) in case money is withdrawn before 3 years and LTCG(long term capital gain) tax( basis an individual’s tax slab) if withdrawn after 3 years.
Should You Invest in Floating Rate Funds?
Floating rate funds are suitable for people who are looking to invest with a time horizon of 3 years which makes these funds tax-friendly as well. These funds give a higher return in a rising interest rate scenario and lesser returns in a falling interest rate scenario. In a falling interest rate scenario, the returns from these funds are closer to or slightly higher than liquid funds.
However, if you are looking for that extra 1-2% over floating rate funds, you can invest in low duration funds or short term debt funds. These funds are steadier and avoid any interest rate risk, the returns are aligned to movement in interest rates. However, one needs to be careful of the credit quality of the floating rate fund portfolio before investing.
In the current scenario, we do not recommend investing in floating funds since interest rates are on a downward spiral and returns could be similar to liquid funds. Also, liquid funds do not have any credit risk, so it is better to invest in liquid funds if you are looking for very low risk and safe option.
To know the best five floating rate debt funds to invest in, you can read another post of ours-Five Best Performing Floating Rate Debt Fund.