“Interest” increases in floating funds
With interest rates slowly rising to pre-Covid levels, floating rate debt funds – also known as floating funds – have been in the spotlight of late.
CRISIL’s analysis shows that during the six-month period ended August 31, 2021, a period that saw stable or rising interest rates, variable rate funds (direct plan) generated the best returns of 3, 40% against 1.66-3.10% for the other categories. of similar duration and composition.
Unsurprisingly, investor interest increased, with August posting net inflows of 9,991 crore. This is the highest monthly net flows on record for the category since April 2019, when the India Mutual Fund Association (AMFI) started disclosing detailed information.
Additionally, flows into existing funds and new fund launches, coupled with the accumulated gains, brought the category’s assets under management (AUM) to a record 94,751 crore at last count.
What are they investing in?
According to the definition of the Securities and Exchange Board of India, these funds must invest at least 65% of their investments in floating rate instruments. In practice, part of these funds consists of synthetic exposures in the form of interest rate swaps such as overnight index swaps (OIS).
A portfolio analysis of variable rate debt funds for the month of August shows that the allocation of FRBs (variable rate bonds) in floating funds currently ranges from 0% to around 56% of the net asset value of the plans, the rest of the corpus being parked in short and medium term fixed coupon bonds which are then converted into synthetic floating positions via swaps.
The main reason for such synthetic exposure is the limited supply of FRBs in India.
In the June quarter, there were 1.74 lakh crore floating corporate bonds outstanding in the market, which was only 4.81 percent of the total outstanding corporate bond issues. Likewise, the share of FRBs issued by the RBI in the previous fiscal year was only 6.5% of total government issues.
The tight FRB market in India is pushing fund managers to use derivative instruments such as OIS to convert fixed coupon bonds of variable duration into synthetic floating positions and thus meet the regulator’s holding requirements.
What fuels their growth?
Floating rate debt funds fare better than comparable categories in interest rate scenarios such as the current one because they invest some of their money in instruments such as floating rate bonds or derivatives. converting fixed rate coupon bonds into synthetic floating positions.
Today, although the Reserve Bank of India (RBI) continues to hold interest rates at historically low levels, its flexible interest rate regime appears to be on the verge of running out of steam due to a high inflation, a large budget deficit and discussions on the normalization of monetary policy from the major central banks are looming on the horizon. For now, the RBI is taking small steps towards the exit.
CRISIL expects this calibrated liquidity withdrawal to continue and accelerate as more definite signs of an economic recovery become visible. The expectation, however, is based on keeping growth on track.
A two-step signal is expected by the end of this financial year: a change of position from accommodating to neutral, followed by an increase in the repo rate by 25bp to 4.25%.
This, in turn, will push domestic yields up from current levels. After rising from a high of nearly 6.70% before the pandemic to nearly 5.70% after the lockdown, the 10-year government security yield (G-sec) rose again to trade around 6.20%. By March 2022, we expect this return to firm up to 6.50%.
Interest rates and bond prices have an inverse relationship – rising interest rates lower bond prices and boost bond yields, and this is especially true for long-dated papers.
However, OIS swaps offer market-linked returns because their rates are reset periodically based on the prevailing interest rates. An OIS can be classified into a fixed leg (where the investor pays a fixed coupon) and a floating leg (where a daily compounded OIS return is received).
As the attached chart shows, OIS rates trended upward during the study period. These increased OIS rates, together with spreads, increased the value of swaps and, in turn, supported the returns of floating rate fund systems.
Advance with caution
Among other benefits, due to their structure, variable rate debt funds provide investors with hedge against rising interest rates. In addition, like other categories of debt mutual funds, a holding period of more than three years offers an indexing advantage, thereby reducing the overall tax payable on investment gains.
In addition, the government’s plan to borrow up to 48,000 yen crore through FRBs, out of a total of 7.24 lakh crore auction borrowings targeted during the first half of this fiscal year, is expected to promote a healthy participation in this avenue.
Investors should note, however, that the performance of FRBs is subject to factors such as the time of entry, reset dates and the liquidity of these instruments.
These funds are also vulnerable to the risks – credit, interest and liquidity – typically associated with fixed income instruments, which can result in short-term capital losses. To give a context in terms of credit quality, according to the August 2021 portfolio, the assets of AAA-rated securities, cash and government-backed securities varied between 80 and 100% and those of instruments rated -AA and below. at about 0-5%. for the plans of the category,
To assume, investors should look at specific portfolios before making an investment decision. Finally, a sharp rise in yields and / or a delay in dismantling the central bank’s lax monetary policy could have an impact on yields.
The author is director, Funds Research, CRISIL