Covid-19 outbreak had led to the persistence of a low-interest rate regime, thanks to the accommodative stance adopted by the Reserve Bank of India (RBI) and pumping liquidity into the system.

The reducing interest rate cycle is beneficial for debt funds, for the existing securities issued at higher coupons attract premium valuations. However, when the interest rates start increasing, the portfolio valuations may take a hit for fixed-income debt securities. This is referred to as interest rate risk, which reflects the change in valuations of the debt portfolio due to the change in market interest rates.

Post the pandemic, there was a reversal in the trend, with interest rates starting to trend upwards. In such scenarios, debt investors must manage their interest rate risks to protect their investments from MTM (Mark-to-Market) losses. This is where a floating rate fund comes to the rescue of investors.

What is a floating rate fund?

A floating rate fund, or 'floater fund', is a debt mutual fund that invests at least 65% of its net assets in floating rate instruments. Floating rate instruments carry a coupon rate linked with an external benchmark, e.g., the 3-month T-Bill, Repo rate, MIBOR (Mumbai Inter-Bank Offer Rate), G-sec yields, etc.

The coupon rate is expressed as the benchmark rate plus applicable spread for the issuer company, for example, 5-year G-Sec yield plus 60 bps, 3-Month T-Bill plus 65 bps, 3-Month T-Bill plus 100 bps, etc. . Since the interest rates for such bonds are reset on a periodical basis, the interest rate changes may not significantly impact the portfolio valuations.

Further, floating rate funds may also carry investment exposure in fixed-rate securities converted to floating rate securities through interest rate swaps. In such strategies, the fund may invest in fixed- rate bonds and enter into interest rate swaps to convert such exposure into floating-rate exposure. With such a strategy, investors can potentially mitigate the MTM impact of the fixed-rate debt portfolio with the inverse MTM impact on the swap valuation.

Such funds favour investors in the rising interest rate scenario since it lowers their interest rate risk. Retail investors may prefer to invest in floating-rate funds in the current scenario, as reflected in the monthly data released by the Association of Mutual Funds in India (AMFI).

Such funds attracted net inflows of Rs. 9,991 crores in August 2021, the highest in the debt fund category and second only to Balanced Advantage Funds. Considering the overall Assets Under Management (AUM), floating rate funds have around a 6% share amongst the open-ended debt schemes with an AUM of Rs. 0.95 lakh crores as of August 31, 2021.

How do floating rate funds generate returns?

Floater funds tend to generate returns for investors through accrual income and valuation changes. The primary income generation is through the interest income on debt securities. While such income is paid to the investors on a periodical basis by the issuer companies, the interest income is accrued daily in the portfolio valuation.

Further, there might be favourable valuation changes to the debt portfolio owing to the changes in the credit spreads for the issuer company. When a company's credit rating improves, the credit risk premium for such companies may be lower. This makes the existing debt securities issued with a higher margin over the benchmark rate more favourable, thus providing MTM gains to the debt portfolio.

Taxation for investments in floating rate funds

An investor may receive income from floating rate funds through distributed income and capital gains. While distributed income is taxable at the regular tax rates applicable to the investors, special tax rates may be applicable for the capital gains.

The capital gains are classified as Short-Term Capital Gains (STCG) if the investor has held the units for less than 36 months. If the units have been held for 36 months or more, the gains are classified as Long-Term Capital Gains (LTCG). STCG from debt funds are taxed at the regular tax rates applicable to the investor. However, LTCG is taxed at 20% (plus applicable cess and surcharge) with indexation benefit. The indexation benefit increases the cost of investment for tax purposes, which effectively lowers the tax incidence for investors.

With floating rate funds enabling the investors to benefit from the higher interest rates in the future, investors may consider investing in such funds.

Disclaimer:
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

The tax provisions mentioned in the article are for illustrative purposes only and updated as per the Union Budget presented in the Parliament in February 2022. The tax rates for capital gains will be as per the tax laws applicable on the date of redemption/ sale.