How do floating rate bond funds protect against interest rate risk?

Floating rate bond funds are designed to mitigate the impact of interest rate risk on an investor's portfolio. These funds invest primarily in bonds that have interest rates that adjust periodically in response to changes in the benchmark interest rates. This mechanism provides protection against rising interest rates, making them an attractive option for investors seeking to minimize interest rate risk.

How Do Floating Rate Bonds Work?

Floating rate bonds, also known as variable-rate bonds, have interest payments that adjust periodically based on a reference rate, such as LIBOR (London Interbank Offered Rate) or the Federal Reserve's federal funds rate. This means the bond’s coupon rate (interest rate) is not fixed; instead, it is tied to the movement of the benchmark rate, which can change over time.

Adjustment Period: The interest rate on these bonds is typically adjusted every 6 months or 1 year, which means the coupon payment can increase or decrease based on changes in the reference rate.

How Do Floating Rate Bond Funds Protect Against Interest Rate Risk?

Interest rate risk is the potential for bond prices to decline as interest rates rise. This is because, when rates go up, newly issued bonds offer higher yields, making older bonds with lower yields less attractive. However, floating rate bond funds are less affected by this risk because their coupon rates adjust with market rates, providing a natural hedge against rising interest rates.

Protection Mechanism: When interest rates rise, the coupon rates on floating rate bonds increase as well, helping investors maintain competitive yields even as bond prices might fall. This dynamic allows floating rate bonds to be more resilient to interest rate changes than fixed-rate bonds.

Benefits of Floating Rate Bond Funds

• Lower Interest Rate Sensitivity: Floating rate bond funds are less sensitive to interest rate increases compared to traditional bond funds, making them an attractive option during periods of rising rates.
• Higher Yield Potential: As the benchmark interest rates rise, the yield on floating rate bonds also increases, offering potentially higher returns in a rising interest rate environment.
• Reduced Duration Risk: Duration is a measure of a bond's sensitivity to interest rate changes. Since the interest rates on floating rate bonds adjust, these bonds typically have lower duration risk, providing better protection when interest rates rise.

When Should You Consider Floating Rate Bond Funds?

Floating rate bond funds are particularly useful during periods of rising interest rates. When central banks, such as the Reserve Bank of India (RBI), decide to increase interest rates to control inflation or stabilize the economy, fixed-rate bonds can suffer losses. Floating rate bond funds, on the other hand, offer protection against such risks due to their ability to adjust the coupon rate based on market rates.

Best Fit for: These funds are ideal for conservative investors who are concerned about interest rate risk but still want to participate in the bond market. They are especially beneficial for those who anticipate rising interest rates in the near future.

In conclusion, floating rate bond funds are an effective way to mitigate interest rate risk. They provide a dynamic approach to bond investing by adjusting coupon rates in response to market interest rates, ensuring investors are better protected in rising rate environments. If you are concerned about interest rate hikes and want to maintain yield stability, floating rate bond funds could be the right choice for you.