Floating Rate Funds

A Floating Rate Fund is a debt-oriented mutual fund scheme that generates income by investing primarily in floating rate instruments. Unlike traditional fixed-rate bond funds, where the interest payment remains constant throughout the bond’s tenure, the coupon on floating rate instruments is reset periodically based on benchmark rates.

Key features include:

• Minimum 65% allocation to floating rate instruments (including fixed-rate instruments swapped to floating exposure, as permitted by SEBI).
• Coupon rates linked to market benchmarks.
• Lower interest rate sensitivity compared to long-duration fixed-rate bond funds
• Market-determined returns.
• Open-ended structure, offering daily redemption.

These funds generally aim to generate accrual-based income while managing interest rate volatility. However, performance remains subject to credit conditions and broader market dynamics.

How Do Floating Rate Funds Work?

Floating rate funds are managed in accordance with the investment mandate specified in the Scheme Information Document (SID). Portfolio construction focuses on instruments with inherent floating rate features or those converted to floating rate exposure via derivatives.

Coupon Reset Mechanism

The key characteristic of floating rate instruments is the reset feature. For example:

• A bond may offer a coupon of Repo Rate + 1.25%.
• If the repo rate increases from 6% to 6.50%, the coupon is reset upward.
• If the repo rate declines, the coupon is adjusted downward at the next reset.

The reset mechanism helps mitigate the price decline typically observed in fixed-rate bonds during rising interest rate scenarios.

Synthetic Floating Rate Exposure

Certain funds may use interest rate swaps to convert fixed-rate bond exposure into floating rate exposure. This enables the fund to meet SEBI’s 65% allocation requirement when direct floating rate instruments are unavailable.

Return Generation

Returns are generated through:

• Interest Accrual: Periodic coupon income from portfolio holdings.
• Mark-to-Market Adjustments: Price movements due to changes in credit spreads or liquidity conditions.

Floating rate funds aim to minimize interest rate sensitivity; however, they remain subject to NAV volatility.

Advantages and Disadvantages of Investing in Floating Rate Funds

Advantages

• Lower Interest Rate Sensitivity
  The periodic reset feature reduces the impact of rising interest rates compared to fixed-rate long-term funds.
• Income Adjustment Feature
  Coupons reset in line with benchmark rate movements.
• Potential stability in rising rate cycles.
  Floating rate funds may exhibit lower volatility during interest rate tightening phases.
• Diversified Debt Exposure
  Investors acquire exposure to various corporate and money market issuers within a regulated mutual fund structure.
• Liquidity
  Floating rate funds are usually open-ended, which means they can be redeemed on any business day.

Disadvantages

• Credit Risk
  Corporate floating rate instruments are subject to credit rating downgrades and default risk.
• Lower Income in Falling Rate Cycles
  Coupon income resets downward when benchmark rates decline, potentially reducing overall returns.
• Liquidity Constraints
  During periods of market stress, liquidity in corporate debt markets may diminish.
• Expense Ratio Impact
  Management and operational costs reduce net returns.

Who Should Invest in Floating Rate Funds?

The investors who may consider floating rate funds include those who:

• Anticipate rising or volatile interest rate environments.
• Seek lower duration risk within their debt allocation.
• Have a short- to medium-term investment horizon.
• Prefer accrual-based income strategies.
• Understand credit and liquidity risks associated with corporate debt

Suitability depends on the investor’s financial goals, risk tolerance, and overall asset allocation strategy.

How to Invest in Floating Rate Funds?

Investors who may consider floating rate funds include those who:

• AMC websites: Investors are able to invest directly on the official website of the mutual fund house by choosing either the Direct Plan or Regular Plan.
• SEBI-registered mutual fund distributors: Distributors and financial advisors facilitate investments in Regular Plans and assist with documentation and portfolio allocation.
• Online investment platforms: These platforms enable investors to compare floating rate fund schemes across multiple AMCs.
• Registered brokerage accounts: Stockbrokers offering mutual fund investment services through their investment or trading platforms.

Pre-Investment Requirement

Individuals must complete the Know Your Customer (KYC) process before investing, as mandated by SEBI. This requires submission of PAN, identity proof, address proof, and bank account details.

Investment Modes

Investment in floating rate funds usually includes the following:

• Lump Sum Investment: A one-time investment made at the prevailing NAV.
• Systematic Investment Plan (SIP):A regular investment made at fixed intervals, subject to scheme availability.

Minimum Investment Amount

The minimum investment varies by scheme, and it is specified in the Scheme Information Document (SID) and Key Information Memorandum (KIM). Generally, lump sum investments start from ₹1,000 to ₹5,000, while SIP installments may begin from ₹500 or ₹1,000.

Investors should review the scheme documents, such as risk factors, asset allocation, expense ratio, and exit load structure, before deciding to invest.

Factors to Consider While Investing in Floating Rate Funds

Floating rate funds are designed to reduce interest rate sensitivity, but they still carry other fixed-income risks. Investors should evaluate the following parameters prior to investment:

1. Benchmark Dependency
   Returns are closely linked to changes in benchmark interest rates, such as the RBI repo rate, treasury bill yields, or other money market benchmarks.Coupon income increases upon reset when benchmark rates rise. On the other hand, the declining rates can decrease earnings. Understanding the prevailing interest rate cycle is important before investing.
2. Credit Quality
   Floating rate funds may invest in corporate debt and money market instruments. While the portfolio may comprise highly rated securities, credit downgrades or issuer stress can impact the NAV.  Issuer concentration and credit rating distribution are useful indicators for assessing credit risk.
3. Modified Duration
   Although floating rate instruments reduce interest rate sensitivity, they still carry residual duration risk. Modified duration measures how much the NAV may change in response to interest rate movements. Investors should align the fund’s duration with their intended holding period.
4. Expense Ratio
   The expense ratio is the sum of the management fee and operating costs imposed by the fund. Higher cost reduces net returns in the long run.
5. Exit Load
   Certain floating rate funds may impose exit loads if units are redeemed within a specified period. Investors should review exit load structures to understand potential early redemption costs.
6. Liquidity Conditions
   In stressed market conditions, corporate debt markets can face liquidity constraints. Limited liquidity can affect the pricing and valuation of underlying instruments, leading to NAV fluctuations.
7. Macroeconomic Environment
   Inflation trends, RBI monetary policy, fiscal developments, and systemic liquidity conditions influence benchmark interest rates. These factors directly impact coupon resets and portfolio performance.
8. Investment Horizon.
   Floating rate funds are generally suited for short- to medium-term investment horizons. Investors should align their holding period with the fund’s duration profile and reset mechanism to manage volatility.

Investors are advised to review the Scheme Information Document (SID), Key Information Memorandum (KIM), Riskometer classification, and monthly portfolio disclosures before investing.

Taxation of Floating Rate Funds

Floating rate funds are classified as debt funds for the purpose of taxation. In Debt funds, equity investment does not exceed 35% of the portfolio. For such funds, the gains are taxed as follows.

Purchased before 1st April 2023	LTCG tax @ 12.5% (if holding for more than 2 years) STCG tax at applicable slab rates when computing income tax
Purchased after 1st April 2023	Tax at applicable slab rates when computing income tax (irrespective of holding period)

Tax laws are subject to change. Investors are advised to refer to current tax regulations or consult a tax advisor before investing.

Conclusion

Floating Rate Funds offer exposure to interest rate-linked debt instruments within a regulated mutual fund framework. The periodic coupon reset mechanism makes them less sensitive to rising interest rates compared to standard fixed-rate bond funds. These funds are, however, prone to credit risk, liquidity risk, and market volatility.

Investment decisions should be based on an assessment of financial goals, risk tolerance, and portfolio allocation requirements. Investors should rely on scheme disclosures and avoid making decisions solely based on short-term interest rate expectations.