Floater Debt Funds: What are They?

6 mins read

Floater funds try to mitigate the risks by investing in debt funds, including corporate bonds, certificates of deposits, treasury bills, etc., providing varying rates of returns based on market conditions or benchmark index.

Floater funds have become popular because they allow investors to earn returns based on business cycles. These funds have a self-adjusting feature to fine-tune with the changing interest rate environment. Floating funds offer benefits from managing interest rate risks by changing debt-fund allocation and swaps. Fund managers use these techniques to manage the duration of investment for the optimal mix.

Asset management companies offer numerous floater funds, meaning you can select one according to your financial goals and capitalize on the changing interest rate in the debt market.

What are floater funds?

Floater funds are mutual funds where the fund managers invest the corpus in various debt instruments allowing it to adjust with the changing interest rate environment for higher returns. It allocates a significant part of the corpus in debt instruments with floating interest rates and takes advantage of changing interest rates to generate quality returns for investors.

Floating rate instruments are unlike other debt instruments like bonds, which have fixed rates of interest. Interest rates of floater debt instruments change with market conditions, and they follow a specific market benchmark. Hence, when the interest rate in the debt market rises, returns from floater funds also increase, making these a preferred investment option for investors interested in debt funds.

Features of floater funds

These are the prominent characteristics of floater funds.

Contains a mixed portfolio of debt securities

Floater funds allocate primarily in various debt securities with floating interest rates and the remaining in fixed-income securities. This diversification allows investors to receive better returns from the changing interest rate regime.

Less risky

Floater funds are suitable for low-risk investors since they invest in debt securities. Compared to equity funds, floater funds are less risky and secure investment options. However, these funds are slightly more volatile than traditional debt funds and carry credit risk when the issuer defaults in paying interests. Therefore, investors need to choose a floater fund carefully that invest in high credit rating securities.

High returns

Floater funds often generate higher returns in the long run. Unlike short-term debt funds, these funds are less volatile to short-term interest rate changes. When the interest rate rises, investors can leverage the benefits by investing in floater funds.

Open-ended scheme

An advantage of floater funds is that they are open-ended, meaning investors can invest in these funds any time of the year, depending on their needs. However, floater funds only allow lump sum investment, and SIP is not available. Hence, timing the market becomes crucial to receive maximum benefits.

Taxation

Like any mutual fund investment, capital gains from floater funds are taxed per capital gain tax rules. A short-term capital gain tax will be levied on the profit earned for fewer than two years of investment tenure. And for an investment duration of more than three years, long term capital gain at the rate of 20% will be levied with the benefit of indexation.

Who should invest?

Floater funds can be used for portfolio diversification to dilute risk for investors with extensive exposure in equity. These funds will help to moderate the risk of any high-risk investment in your portfolio.

Investors unwilling to take high risks associated with equity investment can invest in floater funds since they allot their funds primarily in debt securities with floating interest rates. These allow them to earn higher interest returns than bank deposits.

Floater funds perform even during fluctuating market conditions. Hence, you can allot a portion of your portfolio in these funds after analyzing the NAV value.

What are the types of floater funds?

There are two primary types of floater funds available for investing.

Short-term floater funds: These funds invest primarily in short-term debt securities like T-bills, certificates of deposits, and government securities.

Long-term floater funds: As their name suggests, a significant portion of the fund gets invested in variable interest securities and the rest in fixed-income securities.

Interest rate and floater funds

The returns on floater funds get heavily affected by the changes in the interest rate in the market. Any increase or decrease in the repo rate by the RBI affects the returns on zero risk securities and the bonds issued by the government and public limited companies.

Repo rate refers to the interest rate at which commercial banks borrow funds from RBI by selling their securities to the central bank. An increase in the repo rate also increases returns generated by zero risk debt securities and government bonds, increasing yields of the floater funds.

Simultaneously the interest rate in corporate bonds also increases to counter the increasing demands for government securities. So, increasing the lending repo rate also increases the yield of all the market-linked debt instruments.

In case of a rise in the prevailing market interest rate, the returns from floater funds also increase, making it a profitable investment. It impacts the NAV value of the units implying capital gain for investors.

What are overnight index swaps?

Floating funds invest in securities with floating interest rates or fixed income instruments converted to floating rates using SWAPs or Overnight Index Swaps (OIS).

OIS is a hedging contract involving two parties who agree to exchange or swap the interest payments involving floating or fixed income instruments. The floating leg of the swap is linked with an overnight index. It doesn’t include any cost but a notional contract value in which one party agrees to pay fixed interest and the other a floating rate.

At the end of the periodic adjustment, net profit and loss are calculated, and the net profit position is used to offset the net loss position.

Advantages

Low risk

Because of its low-risk feature, floater funds appeal to risk-averse investors. These funds typically choose among various debt instruments for investment, which allows them to disperse risks and secure the principal component.

Floater funds are less risky than equity investments. Hence, it suits a wide range of investors looking for safer investment options.

High returns

Floater funds benefit from the fluctuating interest rate risks while keeping the principal amount secured. Investing in these tools while the interest rate rises ensure higher yield through the highest compounded interest generated on the principal amount.

Avoid duration risk    

In a rising interest rate scenario, floating rate funds lower the risks from prolonged exposure in the market than fixed-income securities.

Limitations of floater funds

Investing in floater debt funds may sound appealing, but there are a few limitations that you should know before deciding.

The primary limitation is the returns on these funds depend heavily on prevailing interest rate conditions. Secondly, you need to calculate the expense ratio of the funds, which can impact your returns from investment.

The bottom line

Considering the features of self-adjusting to interest rate changes, high liquidity, and low risk of losing initial corpus, floater funds appeal to many investors. These are suitable to investors with low-risk aptitude, who want their principal capital to remain unaffected by stock market fluctuations. However, the yield from the floater funds depends on the changes in the repo rate. The interest portion of return can vary depending upon the policies adopted by the government.

Individuals who aim to diversify their portfolio to dilute risks can allocate a stipulated fund into floater funds. Moreover, these allow investors to gain from the rising interest rate. Hence, individuals who want to make a substantial gain from fluctuating interest rates invest in these funds after procuring the NAV of these funds.

The best time to invest in floater funds is when the interest rate in the market is rising. Any surplus fund parked in these funds during the rising interest rate will result in substantial capital gain.

Understanding floater debt funds – their features, returns, and the best investment time will help individuals make informed investment choices. The duration of investment should match with a market prediction and the overall financial goals of the investor.

 

FAQs

What are debt floater mutual funds?

Debt floater funds invest in debt securities with floating interest rates. Yields from the funds change with the interest rates, offering higher returns to investors when the interest rate/repo rate rises.

What are floating rate mutual funds?

These are mutual funds that primarily invest in floating-rate debt securities (around 65% of the corpus) and fixed-income securities. As a result, these offer capital protection while generating a higher return than bank deposits at low risk.

 Are floater funds good for investment?

Floater funds are good investment options for portfolios that need fixed-income securities. A floater fund invests in various debt and loan securities with floating and fixed rates to earn low-risk returns.

When can I invest in floater funds?

You can invest in floater funds when the interest rate is rising. Since SIP is not allowed in floater funds, one needs to time the market to ensure they receive the highest benefits from investing in such funds.