Floater Funds

When charting out a financial plan, allocating a percentage of your portfolio in investments designed to leverage the fluctuating interest rates can be a great idea. A floater mutual fund is one of the options that serve this purpose, as it yields significant returns when interest rates are climbing.

Floater funds are a type of debt mutual funds, which invest in debt instruments (at least 65%) offering floating interest rates based on market fluctuations or benchmark indices. Corporate bonds, for example, have floating interest rates, while government bonds are fixed-income investments. 

In floater mutual funds, at least 65% of the underlying assets must be invested in floating interest rate bonds such as corporate bonds.

There are basically two types of floater funds, differentiated by their maturity periods. These are as follows:

Short-term Funds

These floater funds invest in debt securities with short maturity periods of less than a year. These securities include high-liquidity instruments, such as government securities, treasury bills, deposit certificates, and more. 

Long-term Funds

These debt floater funds usually have more diversified portfolio compositions, along with longer maturity periods. Along with investing in floating interest instruments, these funds park a significant portion of money in the money market or fixed interest instruments. Corporate bonds, debentures and government securities are among the underlying assets.

Debt funds which invest in fixed-income securities offer you a pre-fixed income, regardless of the business cycle. This limits investors from benefiting from interest rate fluctuations. Floater debt funds address this issue by investing in bonds, which generate returns based on market movements or its benchmark index. 

In fact, there is a direct relationship between the return rates on the underlying bonds and the repo rate set by the RBI. The repo rate is basically the interest rate at which the RBI lends money to financial institutions, such as banks, against government securities.

The RBI keeps adjusting this repo rate based on prevailing inflation in the economy. Thus, an increase in the repo rate leads to increased returns from government securities and, consequently, all market-linked debt securities and bonds.

As such, investing in a floater fund, which consists mostly of such instruments, implies that you could earn significant gains when interest rates increase. Likewise, a fall in the interest rates denotes decreasing income.

There are a couple of benefits of investing in floater debt funds. These are:

• Chance to Earn High Returns

Floater funds in a rising market, have the potential to earn substantial returns, as your interest income is compounded continuously throughout the period.

• Less Associated Risk

Floater funds carry less risk than equity funds due to their underlying composition of secure debt instruments, such as bonds and government securities. This also allows for a greater scope of capital preservation, making it a low to moderate-risk addition to your portfolio.

There are a few risks associated with floater funds, which may pose drawbacks for some investors. These are as follows: 

• High Dependency on the Business Cycle

Floater fund returns rely entirely on interest rate fluctuations and, in a way, on RBI repo rates. A rate cut by RBI will adversely affect the returns you can expect to earn. 

Likewise, volatility in the financial markets may cause drastic changes in the value of your investment, which is not the case with fixed income funds. 

• Credit Risk

Since floater funds invest primarily in securities with floating interest rates, these are more prone to default. For example, corporate bonds with floating rates issued by a private company are riskier than a government bond having a sovereign rating.

There are a few points to keep in mind before pooling your money in floater debt funds. These are as follows:

• Tax Implication

Like with other debt instruments, the returns from floater funds are taxed depending on the period of holding. For investments held for less than 36 months, short term capital gains tax is applicable as per the respective income tax slab. 

For holding periods of 36 months and more, long term capital gains tax is levied at 20%, after adjusting for inflation.

• Investment Horizon

Floater mutual funds generate higher returns in the long run. Hence, it is best to have longer investment horizons of at least a few years.

Floater funds are a good option for investors seeking to gain from rising interest rates while safeguarding their corpus. It can be a useful addition to dilute the risk from aggressive equity allocations in your portfolio. 

These funds also provide investors with a steady flow of income during fluctuations in the stock market. Hence, it could be suitable for market-savvy investors who are confident with their market analysis and wish to earn better returns than those offered by FDs. 

However, the credit risk and interest rate risk are factors which should influence this decision. You can compare top-rated funds and explore a host of investment options on Bajaj Markets start your investment journey today.