The outbreak of the pandemic towards the end of 2019 pushed the entire world into a tizzy. It was indeed unprecedented both in terms of the extent of impact and the breadth of impact. No country was left unscathed and it literally brought the world to a standstill, halting all economic and social activity. In the backdrop of such a landscape, Central banks world over worked in coordination to ensure that fragile growth was not compromised. While governments doled out grants and schemes to help individuals and businesses, central banks worldwide reduced interest rates in no time. The US Federal Reserve set the tone when they reduced the rates in the US to a range of 0-0.25% in March 2020.
India followed suit and reduced interest rates through March 2020 to May 2020 by 115bps. The Reserve Bank of India (RBI) has since ensured that the rates have remained at these historically low levels in order to boost lending and economic activity. Even though the world seems to be clawing its way back out of the pandemic, the RBI has repeatedly assured that the recovery in growth is still fragile and that it needs to be tended properly in order for it to become robust. Further, it has also maintained that the current higher inflation is largely due to supply chain disruption and other parameters that are transient in nature. However, in its most recent monetary policy meeting, the RBI provided a calendar for Variable Reverse Rate Repo (VRRR) indicating the first step as departure from the accommodative monetary policy stance. Now, the expectation is that as the economy picks up, the RBI would gradually increase the interest rates.
What happens when the Interest rates go up?
The price of bonds is inversely related to interest rates. So, if the interest rate is reduced, the price of the bond increases and if the interest rate increases, then the price of the bond decreases. The expectation in the market is that sooner than later the interest rates will start to move up, and the policy rates will be normalized.
In such a scenario what should the investors do as far as their fixed income allocations are concerned?
Well, most of the schemes would actively manage the duration risk to mitigate the increase in interest rate. However, one can also allocate some corpus to Floating Rate funds.
What are floating rate funds?
By definition, these funds invest a minimum of 65% in floating rate instruments. These bonds have a base rate plus spread or margin. For example, the base rate is the repo rate and the spread is 200bps. So, currently the bonds will have 4.00% + 2.00%= 6.00% yield. As the repo rates increase or decrease the yield will change accordingly. In the current scenario, if one expects the interest rates to move up by 50bps, the yield on the said bond would be as follows: 4.50%+ 2.00% = 6.50%. Thus, investors of floating rate funds can benefit through higher yields in an increasing interest rate scenario.
Main benefits of investing in a floating rate fund
• Diversified fixed income portfolio: In a typical fixed income portfolio or a debt fund, the interest rates on the securities are fixed in nature. However, a floating rate fund invests in different types of fixed-income securities with variable interest rates, thereby diversifying the portfolio and reducing overall portfolio risk.
• Substantially reduces duration risk: In fixed income parlance, duration risk refers to risk of a fall in the value of your fixed income investment in response to an increase in interest rates which is usually heightened when you invest in longer duration fixed income securities. Floating rate funds have very low duration risk compared to portfolios that hold longer tenure fixed income securities.
• Provides Flexibility: These funds are usually open ended, thereby giving you the flexibility of choosing when to enter or exit the fund. So, if you envisage an increasing interest rate environment then you can invest in a floating rate fund and if you believe that the cycle is going to change, then you can easily exit the fund.
Floating rate funds aim to optimise the flexibility of managing interest rate risk and enhance investor returns through accrual earnings. Couple with good credit quality and lower net duration risk, these funds can be an ideal solution for fixed income investors who are looking to enhance yield in an increasing interest rate scenario. Of the various floater funds available in the market, one of the funds which has been consistently delivering superior performance is the ICICI Prudential Floating Interest Fund. Across timeframes, be it 1, 3 or 5 year timeframes, the fund is among the top performer.
(The author of this article is Chirag Vejani, Proprietor, Vejani & Company. Views expressed are personal and may not necessarily reflect the views of Outlook Magazine)