6 reasons why floating rate funds are behind the curve

Owing to the smaller size of the floating rate bond market , the supply of floating rate securities is not enough to absorb large flows like during the rush last year. Initially, a bidding war took place among funds where some were compromising on the fixed spread on these bonds. Floating rate bonds were bought at a significant premium, so they could not deliver as per expectations.

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It is also pertinent to note that a large part of the ‘floating rate’ exposure in floating rate funds is actually synthetic. Since there is limited supply of floating rate bonds, most funds synthetically create such exposures by using interest rate swaps. All the fund managers do is to buy fixed rate bonds (mostly government securities and AAA rated corporate bonds) and use overnight index swaps to convert fixed interest exposure into floating. There is always the risk that the interest rate swap does not fully compensate for changes in the underlying bond’s yield.

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As the interest rate reset in floater bonds usually happens at periodic intervals, the higher interest rate kicks in only on the next reset date. As a result of this, spikes in bond yield in the intervening period do not get captured. This time lag prevents floater funds from getting higher returns, particularly when yields rise fast. Besides, reset dates in a portfolio get spread across the year, so all bonds may not capture the period of spiralling yields.

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Moreover, liquid funds and ultra short duration funds invest in very short tenure instruments maturing within 3-6 months. So their portfolios get refreshed quickly, allowing the funds to capture rising near-term yields. The short maturity also leaves these funds less vulnerable to rising interest rates. But floater funds are more exposed to duration (interest rate sensitivity). These do not have to adhere to any regulatory limits on portfolio-level duration. Several floater funds are known to run higher duration in the portfolio. Even among floating bonds, duration remains in play for the period between two interest rate reset dates.

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A swap agreement on individual bonds may not cover them for the entire tenure. For example, a bond maturing after two years may be covered with a swap for only 18 months. This mismatch between the bond’s maturity and the swap term adds to the net duration the fund is exposed to. Besides, floater funds are allowed to park up to 35% of the corpus in traditional fixed rate bonds. The duration built into this unhedged portion continues to drive mark-to-market volatility.

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Some maintain investors may have to hold on to their floater funds for longer portion of the rate upcycle to see tangible gains. A shorter time frame does not make sense even when interest rates climb up. If you exit early, the underlying swaps and reset dates may not entirely come in play by the time of your exit, preventing you from benefiting from the higher yield.

(Text provided by Sanket Dhanorkar)

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