The Mutual Fund Show: How Floating Rate Schemes Can Help As Rate Hike Looms

Manish Banthia: What has happened over the last few years in fixed income is that we have only seen yields go in one direction. From 2014, when 10-year yields were as high as 9.5% to where it is right now around 7%, yields have only come down.

In the shorter end of the curve – the one-to-two-year yields where investors normally invest in bulk – the FD rates have only seen a downward trajectory. Therefore, it is an interesting time to think about what one should do in terms of investments in fixed income when things have changed.

The last two years have been years of recovery for the economy. When the economy is in recovery, there's a different sort of investment opportunity which you need to look at in the markets. But when the economy has moved from recovery to expansion, when capacity utilisations are filling up, your inflationary pressures are moving up. Interest rates in these environments tend to move up.

In a rising interest rate scenario, a fixed yield bond normally may not be the right instrument to invest. In a fixed rate instrument bond, if you have a three-year bond, you're fixing your yield right now. If yields are going to move up, in that journey you are going to lose money.

On the other hand, when yields are going down, if you were investing in a fixed rate bond when yields were moving down, you are actually making more money than the coupon of the bond. So therefore, in a rising interest rate scenario you cannot choose a fixed rate bond because it will come up with a lot of volatility and a lot of pain.

As the interest rate rises, you would like to have better coupons than what you are locking right now. At the same time, you also need to have some capital gains.

Floating rate instruments provide you the solution. These are instruments which are linked to market benchmark rates. It could be either a three-month T-bill, a six-month T-bill, or the Mibor rate which is the overnight rate and they offer a spread over and above that.

As the Reserve Bank of India increases interest rates, the market benchmarks also move and along with a change in market benchmarks, your coupon changes at periodic intervals of time.

For example, the Government of India issues government securities which are linked to six-month T-bill rates, and they are issued in different maturities – five years, 10 years, 11 years. When one chooses to invest in such instruments, if the RBI increases interest rates, the three month and six month T-bill rates will also move up. So, every six months, your coupon is being reset higher.

The beauty of these products is that at present, they are pretty cheap compared to what is being offered by the rest of the market. The spread offered in these products are pretty high. For example, a six-year Government of India floating rate bond is offering a spread of almost 90 to 100 basis points over a six-month T-bill. To start with, you are already getting around 5.5% of income. If the RBI increases interest rates by 100 basis points in the next one year, 5.5% can go to 6.5%.

The overnight index market is already saying that one year ahead, the one-year curve would be at 6.5%. So we are already seeing a sharp increase in the short-term interest rates in the next one year. Therefore, if one invests in these kind of instruments, one not only gets the benefit of higher coupons. Generally, we've seen that as the interest rate moves up, the overall coupon on these bonds becomes attractive for investors and the demand from overall investors also increases.

There is also a chance that the attractiveness at which these bonds are priced right now, that attractiveness can compress, effectively meaning that the yields can compress. When they compress, you get additional benefit out of it.

Something which is available at 100 basis points right now, when interest rates start to adjust at 5.5%, the relative attractiveness from an overall yield perspective becomes higher and people will be okay to buy at 80 basis points rather than 100 basis points. You’re not only gaining the coupon part and the spread, but there are also opportunities to get capital appreciation gains in this segment.

Therefore, from all these perspectives, they are opportune instruments in a rising interest rate scenario. The valuations are pretty cheap and from an overall perspective, as compared to all other fixed interest instruments – be it an FD or any other two-year, three-year fixed interest rate bond – these instruments are looking as the most attractive investment points.

Manish Banthia: The clear option is ICICI Prudential Floating Rate Bond Fund. The strategy in that fund is to invest predominantly in floating rate instruments which are linked to market benchmarks.

As per the last filing, more than 65-70% of the portfolio is invested in these bonds which are linked to either Treasury bills or Mibor kind of benchmarks. Effectively, if one looks to invest for the next one year, at least where it is expected that RBI’s rates are going to push up, these kind of strategies will make a lot of sense.

Manish Banthia: The risk associated with this investment is if for some reason, the economic scenario changes completely and the RBI instead of hiking interest rates starts to think about cutting interest rates. Then, investors might be better off being in a fixed rate instrument rather than a floating rate instrument. But if RBI were to hike interest rates, these instruments should make sense for investors.

Gurmeet Chadha: I partially agree that rates are going up and some part of the portfolio can be considered (for this), but this has to be a satellite bucket. It's not as simple as it sounds. Not all bonds are floating rate instruments. Supply of floating rate instruments hasn't really gone up this year.

It means that as the corpus grows, you have to start doing Overnight Index Swap or OIS, which are swaps to make up. Any floating rate fund has to have 65% exposure to floating rate bonds. And if you don't have so many floating rate bonds available, you go for OIS which are swaps where you exchange a fixed rate with a floating rate. What we saw last year was that despite the rates going up – rates have gone up in the last six months – the performance of most floating rate funds have actually been in line.

If you see the one-year return for most floating rate funds, for all big fund houses it's been around the 3.5% to 4.5% bracket. So, you have to take a call on how much of the yield curve is pricing in.

For example, look at the two-year OIS. That is what is used to swap the fixed rating with floating rate. It’s gone up from 3.8% to 5.7% in the last one year. Let's say if yields don't move at all for the next six months, you are swapping your fixed rate with an OIS rate, so that part of the portfolio which you are hedging may not yield too much. It's a little technical.

Typically, people assume that coupons are getting resettled every day. Coupon gets reset with a bit of a lag. So, it is for more evolved customers.

You have to have a definite view on interest rates, your understanding of the yield curve has to be very good. So, some part of the portfolio can be considered. But it can't be the core allocation in the portfolio. It can be in the satellite, as far as fixed income is concerned.

Mohit Gang: The fact is well-established that rates will go up. It's a matter of “when” and not a matter of “if”. Globally, rates have been inching up. The U.S. Fed has already done the first hike and in India, we are likely to see it soon.

Without a rate hike, the 10-year yields have inched up from almost a low of 5.7% to 7.1%, so there hasn't been a single rate hike for a fairly long time. The 10-year yields have moved. If you see the entire theorem of floating rate bonds – which was the same theorem given last year, and before that also – that when the rate cycle turns away, the floating rate bonds will be very well-established to capture the upside because these are finally floating rate instruments. But I think the technicality is complex.

Minimum 65% of the portfolio has to be in pure floating rate instruments. In India, there are hardly any pure floating rate instruments. So, you go and do these OIS swaps and the OIS swap curve was so steep last year that hardly any of the floating rate funds could give you any return. Even today, the curve is fairly steep.

Unless you see quick rate hikes in succession, which means you're seeing 50-50 bps or something which is beyond the market expectation, that is when a floating rate fund will actually end up giving you a slightly larger return.

For debt, it has to be a very simple strategy. If you really want to play it safe which is the objective of a debt fund, then you have to be at the short end of the curve, play the money market funds ultra-short or at best low duration right now for a minimum of six months to a year.

Once you see that the rate hike cycle has started going up, the yields have fairly risen, maybe you are at around 7.75% inching closer to 8%. That's the time when you start actually moving to the long end of the curve or moving towards instruments which have large maturities and larger durations.

To my mind, it's complex. You have to be a pro in getting into floating rate funds and a pro at coming out also, though the modified durations are not very steep. On paper, it's around one year, but again that's not a pure modified duration because the OIS durations are not counted in it. I will remain away from it as of now and I will play the shorter end for the time being.

Gurmeet Chadha: There are some chinks. I will give you a simple example.

Let's say, I have a five-year bond and the bond coupon is 6.5%. I take a five-year OIS and there it is 5.86%. The interest rate goes up by 100 basis points. I have a 3% mark-to- market impact.

The OIS cover has also been steep. Typically, the rise of OIS is lesser vis-a-vis a plain vanilla bond. Let's say that also goes up 80 basis points. Here I lose 3% and there I gain 2.5%. So, it's a bit of a hedge in terms of not losing out materially in case interest rates go up.

What we have seen in the U.S. is mortgage rates going up to 5%, home sales fell by 10% as per yesterday's data. So it’s a tough job being a central banker, pulling out liquidity, raising rates, ensuring that you don't kill demand.

Some expert investors can take a part of their portfolio. Maybe you're hedging it and 10-20% goes to a Floating Fund. You're hedging yourself that yields go up very sharply in some part of the portfolio and your damage would be contained.

The yield curve is pricing in lots of things. Look at the five-year bond today, it's already touching 6.90%. The two-year government bond, three-government bond rate is below 6%. Right now, the four-to-six-year segment of the yield curve is actually pricing in 50 basis points.

You have to be careful that by doing all this, you're also compromising reinvestment risk. So, let's say you buy a two-year short maturity, you get let's say 5.5%, but if you today buy a four-year or five-year maturity, you're getting 7%. Let's say yields don't change, the reinvestment risk also goes up.

Bucket it carefully – one year money market, long term go where the yields are showing some steepness, keep something in floating, no harm waiting for better yields. So, it has to be a mix and match and balanced approach to the portfolio.

Mohit Gang: Broadly, the short end is where I would park my money. If you want to play the long end, you have to be sure and play the entire cycle out. I'd rather go with a Target Maturity Fund or a Roll Down Fund. Let's say I will go with a Bharat Bond series 2030-31 kind of paper, which are at around 7.40%-7.50%.

I'd rather sit with an FMP (fixed maturity plan). It’s an open-ended FMP and gives you the luxury to get in and get out anytime, and it's the highest quality paper available in the country today. It's also the lowest cost product available in the country today. If you are a debt investor and want to be in debt for a fairly long while, there’s nothing better than that. You stick to your guns and be in a Roll Down Fund.

Floating rate will give you the YTM of the fund more or less if the interest rate hikes are able to match the OIS curve pricing. But unless the rate hikes are very sharp, that's when you make that extra additional 50 bps.

At best, in a floating rate what you make is the current YTM 5.25% roughly odd with 50 bps of aggressive rate hikes, giving you some kind of bonus point out there, making it around 5.55-5.75% kind of return. But chances of that happening are fairly low, because the RBI thus far has refrained from increasing rates. Basically, they have been doing all kinds of tinkering. The yields have gone up, but the rates have not increased. So, it's a tricky job up there.

Mohit Gang: If you see the ten-year crossing 8% – though this time the rate cycle at the low end was also very long. So perhaps, towards the other end also, it could be a fairly long wait before it starts to turn up because inflation seems to be like a real monster this time. The numbers are big and scary. Perhaps the cycle can be a little on the long end.

But beyond 8%, if you go into long-dated funds – and that's been my experience at least in the Indian bond markets, basically in Indian debt funds especially. If you have the patience of waiting and let the 10-year yield cross the 8% mark and then enter long-dated Gilt funds as high maturity as you can. Go and sit tightly there for another year and a half or two years maybe and you will make superlative returns. I have seen investors honestly making high double-digit returns on Gilt funds in the 2003 cycle, and post the financial crisis, there was that one cycle where investors made supernormal returns in Gilt funds.

You have to get the timing right and wait patiently. Even beyond 8%, it can lead to some mark-to-market losses and if you're not patient and tinker around with your portfolio, it won't give you that kind of return.

If you're patient and want a steady flow, corporate deposits at around 7%-7.50% is not a bad bet if you want to lock in for a two-year, three-year kind of thing. Then, you have all these NCDs and other instruments also which keep coming in that range. So those are also decent options for investors who just want to stay put and don't want to play the rate cycle.

Sometimes, you are quite satisfied with getting 7-8% yield. If you know on a confirmed basis you can make that much in two years, you don't have to tinker with your debt portfolio. But for people who want supernormal returns, wait for the yield to cross 8%, then enter the long end. For the time being, the short end is my favoured place.

Gurmeet Chadha: I will do it in three buckets. One bucket where I find the yield curve very steep is the four to six-year bucket. You're already seeing six-year, five-year, seven-year bonds almost touching 7%.

In fact, you'd be surprised, the spread with AAA of five-year and government bonds is only six basis points. Actually, you are not gaining anything by going from the G-Sec to AAA bond as far as the five-year is concerned.

There are a lot of Target Maturity Funds of 2026 maturity, 2027 maturity which are giving you that YTM closer to 6.60%-6.80%. I may be tempted to put something there.

I may not want to go all out but the yield curve is definitely steep. Repo is 4%, shorter end rate is 5.5% and you're getting medium end almost 7%. So, it's pretty steep, probably pricing in 100 basis plus.

At the longer end, I would tend to agree with Mohit. This is again for people who can manage volatility because G-Sec can hit you both sides if yields harden. The yields can harden very quickly also. We saw 25 basis point movement in yields in the last two days on the ten-year. So it is not for the weak-hearted. We did an analysis that the moment it crosses 7.50%, the three-year returns have always been 8%.

Whenever it crosses 7.5% and you hold it for three years, it is typically around 8%. Whenever it crosses 8%, the returns are much better, because then you get a big MTM gain. So for me it is that 7.5%-8% corridor.

Keep some powder dry in liquid ultra-short term for the time. Have some Target Maturity Fund for a three or four-year horizon and keep it a little light. I think an STP in a long-dated G-Sec may not be a bad idea. That can also be considered.

Gurmeet Chadha: I will keep around 25% or 30% in low duration money market instruments. We can choose Birla or ICICI – they are good money market funds and you can choose either. There's not much difference.

Some part I will put in Target Maturity Funds with a three-year view, where I'm getting closer to 7%. There are fund houses which are giving me State Development Loans plus G-Sec portfolio. SDLs are typically at a slightly higher rate. Bharat Bond has gone up to 7.30%-7.40%, but that's a little higher maturity.

The rest of the money I would keep powder dry. Wait for yields to turn a little better. I also don't mind RBI Floating Rate Bonds. That's a genuine floating rate bond, offers you 7.25% and it's indexed to changing rates. It may not be a bad option. Unfortunately, the lock-in is seven years and because it is interest taxation, if you're in a lower tax slab and you want a very long term, it may not be a bad idea.

Mohit Gang: I think 50% of the money will go into Money Market Funds right now or Ultra-Short perhaps, which is the safest place. Then this 50, I will flip it across into G-Sec if I'm a pure play debt guy and I want to play the debt cycle. Then I'll flip this into G-Sec or long-dated Gilt funds once I'm satisfied or know that my threshold yield has crossed and that barrier can be 8% or somewhere around that mark.

On the money market side, I'm fairly comfortable with most of the funds but let's say an ICICI Money Market Fund, Aditya Birla Money Market Fund, or even Tata Money Market Fund has been doing fantastically well, so those are good choices.

On the remaining 50% of the portfolio, around 25% can go into Target Maturity Fund. If the horizon is one to three years, then we're left with choices which mature at around 2026-27 kind of a series. So you take the Aditya Birla Sunlife SDL series out there or you have Kotak and Axis SDL funds. Now, SDL is a mix of state loans plus some G-Sec, so state loans give you that extra bump in the yield. Pure government papers can be slightly low on the yield.

Those SDLs are quoting an yield of around 6.5% roughly, give or take 50 or 25 bps. That could be a good way of capturing that yield being in a target maturity or a Roll Down Fund and it's like an open-ended FMP. It works like an open-ended FMP and the paper quality is absolutely high.

The remaining 25%, I would want to lock it into a corporate deposit. Even RBI Floating Rate Bond, which Gurmeet said is a great instrument if you have the time tenor of locking it for seven years.

But for one to three years, go for a corporate deposit or an NCD of any of the good AAA rated issuers. You're getting around 7.50%.

Mohit Gang: The benefit of indexation kicks in. Let’s say you are buying a Bharat Bond Fund of 2030 maturity where the yield is currently 7.49%, 7.50%. You are making those seven indexations on the way and it becomes highly tax efficient as an instrument. So it’s a great investment.

Gurmeet Chadha: I think if you are going for lock-in, go for indexation.