Most debt funds (especially the ones with higher duration) have seen a dip in returns over the last 2 months as yields have gone up sharply.
The increase in yields were led by concerns on:
- Higher than expected government borrowing programme announced in the budget
- RBI’s intent to normalize the liquidity measures announced during the Covid crisis
- Global Yields going up on inflation concerns
- Possibility of domestic inflation going up led by the expected economic recovery and increase in commodity prices (especially crude)
What is our view?
The past few years of rate cuts are behind us and we are gradually entering a ‘rising interest rate’ environment. Given the context of rising yields, debt funds are expected to be more volatile in the near term and returns for most debt fund categories (barring ones with low duration) are expected to be rear-ended.
If you want to understand the detailed rationale behind our view please check our earlier blog here.
How about Floating Rate Funds?
Usually when yields are expected to go up, a particular category of debt funds called the Floating Rate Funds garner a lot of attention.
As expected, the inflows to this category have started to increase with AMC’s starting to launch new funds in this category.
But why do Floating Rate funds become popular when yields are expected to rise?
This is because floating rate funds are expected to navigate the rising yield environment with minimal near term volatility and can provide higher returns if interest rates go up. This category is usually marketed as a good way to hedge debt fund volatility associated with rising yields.
Does this mean this is a free lunch offering best of both worlds – higher returns as yields move up and lower volatility?
In the financial world, if something sounds too good to be true, then it usually is.
Let us deep dive to find out if Floating rate funds are the magical solution they are made out to be…
Floating Rate Debt Funds – Do they really hedge volatility when yields rise?
What are Floating Rate Funds?
As defined by SEBI, floating rate funds predominantly invest (greater than 65% of the portfolio) in floating rate instruments.
Hang on… What in the world is a floating rate bond instrument?
Think about your Fixed Deposit.
When you invest in a 5 year FD say for 5.5%, then you are essentially locking your FD returns or interest rates at 5.5%. If interest rates after a year, goes up by 1% and becomes 6.5%, you don’t enjoy the higher interest rates as you have already locked in your rates at a fixed interest rate i.e 5.5%.
Assume a hypothetical world, where you are allowed to trade your FD. This will mean your FD becomes less valuable compared to new FDs and hence your FD value will come down.
Similarly, if FD interest rates were to come down to say 4.5%, then your FD becomes more valuable compared to new FDs and your FD value will go up.
Thus interest rates going up leads to decrease in value and vice versa. All this happens because you lock in your interest rate at a fixed rate.
This is exactly what happens in a regular bond paper, where the rates are fixed for a particular maturity period. So the same logic of interest rates going up and lowering the value of bonds and interest rates going down and increasing the value of the bonds, holds true.
If you take a step back, the reason why the price is forced to adjust when interest rates change, is because the rate of underlying interest for these bonds are fixed.
But what if the interest rates of these bonds are not fixed and they change along with the interest rates?
Now the price does not need to adjust right!
Cool. That is exactly what a floating rate bond does.
In this case instead of the interest rate being fixed, it changes along with interest rates. The interest rate of these bonds are usually pegged to benchmarks like Mumbai Interbank Offer Rate (MIBOR). Before you freak out, the MIBOR is simply the interest rate at which banks borrow money from another bank in the Indian interbank market on a 1 day basis.
So whenever the interest rates go up or down, the underlying interest rates for these floating rate bonds automatically adjust up or down accordingly. This means that there is no major price impact as the interest rates have automatically adjusted unlike a fixed rate bond.
So in an environment where interest rates are expected to rise, these bonds typically do well as they reset their yields to higher levels when interest rates go up with minimal price impact.
Now since floating rate bond funds invest a minimum of 65% into such floating rate bonds, this category logically should benefit from increasing interest rates and at the same time have minimal negative price impact.
No wonder this category is becoming popular!
So far so good. But this is still theory!
Let us test out how this category works in the real world. Yields have moved up starting 08-Jan-2021 (when RBI announced measures to normalize liquidity i.e excess money available with banks without being lent).
Did Floating rate funds dodge the volatility?
The Real Test
Yields have gone up by 50-80 bps in the last 2 months starting 08-Jan-2021.
How did floating rate funds fare in this period?
Let us compare this with Low Duration and Money Market Funds?
Floating rate funds have in fact fallen more than other similar categories such as Money Market funds, Low Duration funds.
But weren’t the floating rate funds supposed to have lower volatility and higher returns when yields increase?
What happened to our theory?
Someone care to explain?
Unravelling the mystery…
While our theory was correct, there is a small nuance that we didn’t let you know in the beginning.
In India unfortunately, we don’t have many issuers of floating rate bonds.
As on 30-Dec-20, of the total Rs.35.1 lakh crs outstanding corporate bonds, less than 5% had floating rate structure (ie., Rs.1.6 lakh crs).
While all this time we were thinking from our side, let us shift the perspective to that of the borrower. If you were the borrower, unless and until you are hiding under a rock, obviously you also know that borrowing rates may increase. So if you are borrowing, you would obviously want to lock in the ultra-low current borrowing rates. Why in the world would you issue a floating rate bond to borrow money knowing you will have to pay higher interest rates as they increase in the future.
So no wonder, we don’t have too many floating rate bonds available. The dearth of floating rate bonds, is also reflected in the fact that the entire floater category has only eight funds.
So far so good. But there is a nagging question…
If floating rate bonds are not available and SEBI mandates floating rate funds to have at least 65% of their portfolio in floating rate bonds – how do the funds manage this conundrum?
Here is where we introduce the twist in the tale – while floating rate bonds are rare to get, to work around this constraint, floating rate funds artificially construct a floating rate type of bond – referred to as Synthetic Floating Rate Bonds.
Ummm. Errr. What!?
Before you lose me on this. Let me explain this in detail.
Let us understand this with an example. Assume the fund manager buys a regular fixed rate bond, say a 1 year bond for Rs 1000 crs. This bond pays an interest of 5%. So the fund manager will get a return of 5% from this bond over the next year. This would roughly mean 0.42% per month (i.e 5%/12). This in debt market jargon is called accrual returns.
So far so good. Now how do we convert this fixed rate into floating rate?
Enter Overnight Index Swaps.
An Overnight Index Swap (OIS) is an agreement between two parties in which one party pays a fixed interest rate and receives a floating rate which is linked to a daily overnight reference rate index ie MIBOR
For the same Rs 1000crs, the fund manager gets into an overnight indexed swap agreement for a chosen tenor with a counterparty. The fund manager will pay an agreed fixed interest rate (say for eg 4%) in exchange for receiving the variable rate linked to Overnight rates (i.e MIBOR) from the counterparty. Thus a floating rate structure is artificially constructed.
Each and every day there will be a difference between both.
Daily Mibor return = 3.5% / 365 (this will keep changing)
Daily Fixed rate return = 4.0% / 365 (this is fixed for the tenure)
The differential in rates (can be positive or negative) on a daily basis is added to the daily fund returns in addition to what is obtained via accrual from the fixed rate bond. This will contribute to the stable accrual returns of the fund.
Net Yield = Overnight Rates + Yield from fixed rate bond – Fixed rate paid for OIS
But the actual role of reducing volatility comes from the mark to market component:
If interest rates move up, the price of the fixed rate bond falls (the magnitude will depend on the duration – higher the duration higher the impact).
However, the value of OIS increases as overnight rates move up (the magnitude will depend on the duration – higher the duration higher the impact).
While we might expect both of these to net off each other thus ensuring no declines, here is the catch – Usually, both of these do not net off each other perfectly!
More often than not, the increase in value of the underlying OIS is only able to partially net off the negative decline arising from the fall in prices of the fixed rate bond.
This is how fund managers try to reduce the volatility using a synthetic floating rate bond.
But why is this not a perfect protection or 100% hedge?
- The underlying swap’s tenor is usually different (lower) compared to the maturity of the fixed rate bond. The difference is the underlying net maturity of the fund (i.e average maturity of the underlying bond – OIS maturity). This leads to a net decline in prices when interest rates increase and the extent of the impact will be dependent on the net maturity.
- The OIS market does not always move in sync with the underlying rate environment or the underlying bond yields.
If all this went over your head, no worries – here is all that you really need to understand…
Just like any other debt fund whose interest rate volatility gets determined by the underlying modified duration, floating rate funds also will have a negative impact on prices when interest rates increase. The extent of impact will be based on the underlying net duration of the fund.
Floating Rate Funds – Not the magical solution for increasing interest rates
In theory, floating rate funds have the potential to be a perfect hedge for debt fund volatility during a rising interest rate environment. However, as we saw from actual evidence, floating rate funds are not completely immune to volatility due to rising yields.
This is because of the lack of floating rate bonds in India. Floating rate funds predominantly end up using synthetic floating rate bonds instead. This usually does not perfectly hedge (read as protection from temporary falls) your returns from negative impact in a rising rate environment.
In reality, floating rate funds both in terms of volatility and returns are similar to debt fund categories with low duration – Low Duration Funds, Money Market Funds.
So while we have nothing against this category, it is important to have the right expectations. Please don’t buy into this category with the misplaced expectation of zero volatility and increasing returns.
The volatility profile will be based on the underlying net duration of the floating rate fund (the higher the underlying net duration the higher the negative impact on NAV when yields move up).
As always happy investing!