How do floating rate debt funds work?

Floating rate debt funds are a type of mutual fund that invests in debt securities (like bonds) with variable interest rates that adjust periodically. These funds aim to provide investors with regular income while managing interest rate risk. In this blog, we'll explore how floating rate debt funds work and how they can be an ideal investment choice for a rising interest rate environment.

What Are Floating Rate Debt Funds?

Floating rate debt funds are mutual funds that invest in bonds or other debt instruments whose interest rates are not fixed but instead change periodically. These rates are usually tied to a benchmark like the LIBOR (London Interbank Offered Rate) or the repo rate set by the central bank. As the benchmark rate changes, the coupon rates on these bonds adjust accordingly.

How They Work: These funds aim to protect investors from interest rate risk by investing in debt instruments where the interest rate is adjusted periodically. When interest rates rise, the yields on these bonds also rise, which helps maintain the value of the fund. On the other hand, if interest rates fall, the returns may decrease, but they are generally more stable compared to fixed-rate bonds.

How Do Floating Rate Debt Funds Manage Interest Rate Risk?

Interest rate risk is the potential loss in bond prices due to changes in interest rates. Floating rate debt funds manage this risk effectively by investing in bonds whose interest payments adjust in response to changes in market rates.

Interest Rate Adjustments: The main advantage of floating rate debt funds is that the coupon rates of the underlying debt instruments adjust periodically. For example, if the central bank raises the interest rates, the coupon rates of the bonds in the fund will increase, which helps protect the fund's value from market fluctuations.

Shorter Duration: Floating rate debt funds typically have shorter durations compared to traditional fixed-rate debt funds. This shorter duration means the funds are less sensitive to changes in interest rates, further reducing the risk of price volatility.

What Are the Benefits of Floating Rate Debt Funds?

• Protection Against Rising Rates: Since the interest rate of the bonds in the fund is adjusted periodically, the fund's returns rise with increasing interest rates, providing protection against the adverse effects of rising rates.
• Stable Returns: Floating rate debt funds typically offer more stable returns compared to fixed-rate bonds during periods of changing interest rates.
• Lower Price Volatility: Due to their shorter duration and adjustable rates, these funds tend to experience lower price fluctuations compared to traditional bonds, making them more suitable for conservative investors.
• Suitable for Rising Interest Rate Environment: In periods of rising interest rates, floating rate debt funds can outperform other fixed-rate debt funds as they benefit from higher coupon rates.

When Should You Consider Investing in Floating Rate Debt Funds?

Floating rate debt funds are most beneficial when interest rates are expected to rise. In a low-interest rate environment, these funds may not offer as much of an advantage compared to fixed-rate bonds. However, during periods of rising rates, floating rate debt funds can provide better returns by adjusting their coupon rates accordingly.

Ideal for Conservative Investors: If you’re a conservative investor looking to minimize interest rate risk while still earning a reasonable return, floating rate debt funds could be an ideal choice. They offer stability, lower price volatility, and protection from rate hikes.

Floating rate debt funds are a smart investment choice for managing interest rate risk. With their adjustable coupon rates and lower price volatility, these funds provide stability and protection against the impact of rising interest rates. They can be a valuable addition to any investment portfolio, particularly in an environment of rising rates.