Floating rate fund, an ace up investor sleeve

When investors seek a safe haven for their investments, they usually turn to the liquid or ultra short-term funds. But rarely do investors look at floating rate funds. While they have been in operation for a considerable time now, the share of floating rate funds in the mutual fund industry’s assets under management (AUM) has not been significant, despite some unique advantages over fixed income funds.

A floating rate mutual fund is a debt fund that invests predominantly in debt securities with a floating rate of interest. And these debt securities peg their coupon or interest rate payable to a market-driven rate such as the Mumbai Interbank Offered Rate (Mibor). Hence, each time the benchmark rate fluctuates; the coupon rate is adjusted accordingly.

The primary advantage of these funds is that they are less volatile than other types of debt funds. This advantage arises due to the inherent structure of the floating rate bonds. In case of fixed rate bonds when interest rates in the economy change, the price of the bond adjusts to make up for the fixed coupon of the bond.

While this happens even in the case of floating rate bonds, the change in the price of the bond is less drastic due to the periodic change in the coupon of the bond. The fall in the price of the floating rate bond will depend upon the reset period. The lesser the gap between the resets, the lower will be the fall in price.

The reset could be daily, monthly, quarterly, half-yearly, annually or any other periodicity specified by the issuer. These funds, in turn, ensure that the portfolio has a limited interest rate risk. Under normal conditions, floating rate funds intend to invest minimum 65% of net assets in floating rate securities.

There are two types of floating rate funds — long term and short term. The portfolio of the short-term plan is normally skewed towards short-term maturities with higher liquidity, and the portfolio of the long-term plan is skewed towards longer-term maturities. However, even the longer-term funds are positioned more on the lines of short-term funds and are not very aggressive. Moreover, the volatility arising due to investment into long-dated fixed coupon bearing securities is offset by the presence of floating rate securities.

Performance
When investors consider debt funds, they are essentially looking at keeping their principal safe with the secondary objective of capital appreciation with a minimum risk. Liquid funds’ category maintains the lowest average maturity amongst its other debt counterparts, which is usually around three months.

As a result, liquid funds are least prone to interest rate movements. While ultra short-term funds’ category maintains an average maturity slightly higher than liquid funds, it is generally in the range of 6-12 months. Both liquid funds and ultra short-term funds usually invest in instruments having fixed coupon rate. On the other hand, floating rate funds invest in instruments having variable coupon rate.

Looking at the performance table over different time frames, floating rate funds have delivered outstanding performance over the years and more importantly, with considerable consistency. Floating rate funds have outshined liquid funds and ultra short-term funds across all time frames as of July 8, 2009. A look at the year-on-year performance also reveals a better consistency in delivering higher returns when compared to other type of funds.

Let’s take the shortest investment period of one day and see how floating rate funds fared against liquid funds and ultra short-term funds over the past two years as of July 8, 2008.

We are assuming that the investor has been investing since July 8, 2007 to July 8, 2009 only for one day on a daily basis. Out of 55 liquid funds, eight funds have delivered negative returns at one point or the other over the past two years. Rest of the fund has shown an appreciation consistently every day throughout these two years. Out of these eight negative performers, ING treasury management was the worst performer, which gave negative returns 17 times over the two-year period.

Ultra short-term funds, which are more vulnerable to interest rate movements than liquid funds, have shown better resilience over the past two years. Out of 43 ultra short-term funds, only five have delivered negative returns, one or more times. Mirae Asset Ultra Short Term Bond Fund, which was the worst performer, has delivered negative returns six times. While the other four negative performers have delivered negative returns only once.

Out of 25 floating rate funds, 12 have delivered negative returns over this performance period. However, out of these 12 negative performers, only six funds have given negative performance more than two times over the past two years. A closer look reveals that the schemes that most frequently slipped into negative were also more aggressively positioned than an ordinary liquid or ultra short-term debt fund. In some cases these funds have upped the average maturity of their portfolios through investments in medium- to long-term dated government securities. Therefore, when it comes to keeping principal investment secure, floating rate funds are able to match the safest types of funds.

Credit quality
Credit quality is the measurement of a bond issuer’s ability to repay the debt. Investment into AAA and equivalent rated instruments, call money market and government securities are the safest and most liquid instruments, while below AAA and equivalent rated instruments reflect downgraded quality and lower liquidity. However, their lower quality results in better returns, albeit at a higher risk.

Over the past two years as of June 30, 2009, floating rate funds category have invested 82% of the net assets on an average into high quality papers, including AAA and equivalent instruments, government securities and call money market.

Rest of the net assets were invested into below AAA and equivalent rated instruments and unrated instruments. At the same time, liquid funds over the past two years have invested 85% of the net assets into high quality papers as of June 30, 2009 (latest portfolio).

Similarly, ultra short-term funds have invested 84% of the net assets into high quality papers including AAA and equivalent instruments, government securities and call money market as of latest portfolio June 30, 2009.

Overall, credit quality of floating rate funds’ category is more or less similar to liquid funds and ultra short-term funds. Average maturity doesn’t play a very important role in case of floating rate funds as they invest in instruments, which have a variable coupon rate.

Inflows
Corpus of the floating rate funds’ category stood at Rs 11,119 crore as of June 30, 2009. On the other hand, corpus of the liquid funds’ category and ultra short-term funds’ category stood at Rs 1,30,608 crore and Rs 1,84,484 crore, respectively revealing humungous difference in the inflows between floating rate funds’ category and liquid and ultra short-term funds’ categories. The maximum corpus that floating rate funds’ category had over the past two years was Rs 21,410 crore and that was at the end of April 2008. This is again significantly lower than the corpus of liquid funds and ultra short-term funds.

Unique selling point
The biggest advantage in case of floating rate funds is their ability to deliver stable returns. When interest rates harden, floating rate funds deliver better returns than their usual returns. While in such a scenario, funds which invest in fixed coupon paying instruments i.e. other than floating rate funds, start witnessing a discernible weakness in performance.

On the other hand, when interest rates ease, funds, other than floating rate funds, start appreciating at a better pace. However, floating rate funds do not deviate very significantly in terms of performance.

Conclusion
The primary reason for their lacklustre presence in the mutual fund industry has been investor ignorance of the nature of floating rate funds. Their performance reveals that they can be a good investment option even for the shorter term, which has otherwise been dominated by liquid funds and ultra short-term funds.
In case of a longer investment horizon of more than a year, the longer-term floating rate funds offer an unmatched ability to maintain stability.