What are Floater Mutual 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.

Advertisement

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 53,215.90 crore with 13 schemes with the oldest being 23 years old, and the category ranked 9th in the list of open-ended debt funds according to the Association of Mutual Funds in India (AMFI).

Who should invest in Floater Funds?

For investors looking to capitalize on rising interest rates, Floater Funds could be a viable choice. They offer the benefits of portfolio diversification and safeguarding against interest rate risk. However, it’s important to note that these funds come with inherent risks.

Taxation of Floater Funds

 

  Short Term Capital Gains (STCG) Tax Long Term Capital Gains (LTCG) Tax
Before 1st April 2023 All gains registered within 3 years from the investments are taxed at your marginal income tax rate. All gains registered after 3 years from investments are taxed at a 20% flat tax rate with the benefit of indexation.
After 1st April 2023 Same as above 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

Advantages of Floater Funds

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. For example, HDFC Floating Rate Debt Fund portfolio is constructed with more than 70+ corporate bonds (as of February 29, 2024).

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.

Disadvantages of Floater Funds

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.

https://www.rbi.org.in/