With interest rates slowly tracing their way back to pre-pandemic levels, floating rate debt funds – also referred to as floater funds – are in the limelight of late. Crisil’s analysis shows that in the six months ended August 31, 2021, a period that saw flat or rising interest rates, floating rate funds have generated the best returns of 3.40% compared with 1.66-3.10%¹ for other categories of similar tenure and composition. Not surprisingly, investor interest has surged, with August witnessing net flows of Rs 9,991 crore. This is the highest monthly net flows for the category on record since April 2019, when the Association of Mutual Funds in India (AMFI) started detailed disclosure. What’s more, flows into existing funds and new fund launches, coupled with accrual gains, have taken the assets under management (AUM) of the category to a record Rs 94,751 crore at the latest count.

What do floating rate funds invest in?

According to SEBI definition, these funds need to invest a minimum of 65% of their investments in floating rate instruments. In practice, a chunk of these funds consist of synthetic exposures in the form of interest rate swaps such as overnight index swaps (OIS).

A portfolio analysis of floating rate debt funds for August shows that allocation of FRBs in floater funds currently ranges from 0% to ~56% of the schemes’ net asset value, with the rest of the corpus being parked in short- and medium-duration fixed-coupon bonds that are then converted into synthetic floating positions through swaps.

The primary reason for such synthetic exposure is the limited supply of FRBs in India. As of June, there were Rs 1.74 lakh crore corporate floating bonds outstanding in the market, which accounted for a mere 4.81% of the total outstanding corporate bond issuances. Similarly, the share of RBI-issued FRBs during last fiscal stood at only 6.5% of total government issuances.

The constrained FRB market in India drives fund managers to use derivative instruments such as OIS to convert the fixed-coupon bonds of varying tenures into synthetic floating positions and thereby meet the regulator’s holding requirement.

¹ Direct plans have been considered for the performance analysis