Floater Funds

Floater funds are open-ended debt mutual fund schemes that invest at least 65% of their assets in floating rate instruments.

Floating rate instruments have a coupon rate linked to an external benchmark, like the repo rate. The coupon rate for floating rate bonds is typically expressed as the benchmark rate plus risk spread applicable to the issuer company. Consequently, one can’t estimate the returns of these funds at the start of investment.

For an issuer with risk spread of 2.5% above the repo rate (6.5% as of Feb 2024), the floating rate will be: 

Repo rate + risk spread i.e., 6.5%+2.5%=9%

Source: RBI website as of February 29, 2024

Assuming that the risk spread doesn’t change, the floating rate offered by this bond will change whenever the repo rate changes.

As of February 29, 2024, this fund category has assets under management (AUM) of Rs 53,215.88 crore with 13 schemes, and the category ranked 9th in the list of open-ended debt funds.

Source: AMFI website as of February 29, 2024

While you should identify your risk profile and plan your financial goals before investing in floater funds, here are some situations where they may fit in:

Alternative to Bank Fixed Deposits

As of February 19, 2024, the annual return for floater funds is between 7.5-8.6%. On the other hand, interest rates offered by large banks range between 6.60-6.85%. You can see that they give you better returns than bank fixed deposits, although they are market-linked and can fluctuate.

Source: Valueresearch, SBI, HDFC Bank, ICICI Bank, BOB websites as of February 19, 2024

Note: While floater funds are good alternatives to bank fixed deposits, they are not insured like bank fixed deposits. Bank fixed deposits of up to Rs. 5 lakh per bank account are insured by the Deposit Insurance and Credit Guarantee Corporation (DICGC).

Conservative Investors

Investors with a conservative risk profile seeking a relatively stable income may find floater funds appealing. This is because floater funds can potentially reduce the interest rate risk generally associated with debt funds.

Portfolio Diversification

Investors looking to diversify their portfolios beyond equities can include floater funds to spread risk. Investors with a lower risk tolerance who are uncomfortable with the volatility associated with stocks and equity mutual funds may find floater funds more in line with their risk preferences.

Inflation Hedge

Since the interest rates on floating-rate securities adjust with market rates, floater funds offer a degree of protection against inflation. This can be appealing to investors looking to preserve the real purchasing power of their returns.

Short Term Capital Gains (STCG) Tax

For investments made before 1st April 2023: All gains registered within 3 years from the investments are taxed at your marginal income tax rate.

For investments made after 1st April 2023: Same as above.

Long Term Capital Gains (LTCG) Tax

For investments made before 1st April 2023: All gains registered after 3 years from investments are taxed at a 20% flat tax rate with the benefit of indexation.

For investments made after 1st April 2023: From 1st April onwards, all debt capital gains lose LTCG and indexation benefits and will be taxed like STCG - at your marginal income tax rate.

Dividend Taxation

Floater funds pay out dividends when you invest in their IDCW (Income Distribution Cum Withdrawal) option.

Dividends are taxed at your marginal income tax rate.

TDS (Tax Deducted at Source) at 10% is applicable on dividends received more than Rs 5,000 per AMC per financial year.

Lower Interest Rate Risk

Floater funds perform better than comparable categories in a rising interest rate scenario since the coupons are linked to an external benchmark, hence these funds tend to give higher returns during this period.

Diversification

Floater funds invest in a diversified portfolio of bonds issued by different companies and industries. This diversification helps spread risk and reduces the impact of poor performance from any single issuer.

Lower Volatility

Floater funds may experience lower volatility compared to fixed-rate funds in a changing interest-rate environment. This can be appealing to investors seeking a more stable investment value.

Decreasing Interest Rate Scenario

Because floating rate instruments adjust their interest rates as per the market interest rates, they generate lower returns than fixed rate instruments.

This is because fixed interest rate instruments benefit from a fall in interest rates. This is because they become premium instruments with a fixed interest rate that’s higher than the market interest rates which have fallen.

The disadvantage extends to floater funds against other debt funds which are primarily composed of fixed rate instruments.

Credit Risk

They invest in debt instruments, and as such, they are exposed to credit risk. If there are downgrades or defaults in the credit quality of the issuers of the underlying securities, it can negatively impact the fund's performance.

Limited Capital Appreciation Potential

Bonds have an inverse relationship to interest rates. When interest rates rise, bond prices usually fall, and vice-versa.

Floater funds have limited potential for capital appreciation, especially in comparison to fixed-rate funds since the rates change with respect to the benchmark. This means floating rate funds may not experience capital appreciation like fixed rate funds.