How to ride rising interest rate tide?

Mumbai: You have probably heard floating rates being discussed more in reference to housing loans than investments.

This was so because in the past three years, with interest rates coming down, while investors wanted to be in debt funds that invested in fixed rate instruments, home loan consumers wanted their home loans to offer floating rates to reduce payouts.

Now, when home loan consumers want fixed rates, investors in debt funds are demanding floating rate debt funds.

Actually, understanding this curious relationship will clarify the role of floating rate debt funds too, and thus help you get more out of your debt fund investments.

So lets start with the reason why fixed rate home loans are in demand among home loan consumers? Because interest rates are expected to increase, right?

When interest rates increase, income plans, which are debt funds that invest in long term fixed rate bonds, make a capital loss.

With a rise in interest rates, newer fixed rate bonds available in the market give a higher rate of interest and so fixed rate bonds that income plan fund managers had bought earlier have lesser demand and hence command lesser price than their purchase cost.

It is in periods like these that floating rate debt funds flourish. These are funds that only buy floating rate bonds. Thus when interest rates increase, the floating rate bonds now start receiving a higher interest rate, and therefore they don't lose value like fixed rate bonds.

This is why, when interest rates are bound to increase, home loan consumers demand a fixed rate (to a higher payouts) and debt fund investors demand floating rate funds (to get higher returns).

Now let us understand how floating rate debt funds generate higher returns.

The objective of any floating rate fund is to represent the interest rate environment of the market. Thus if interest rates are rising, its returns should rise and vice-versa.

Floating Rate Funds are protective products. Their rates are always in line with existing interest rates. They provide stable returns under all interest rate conditions.

These funds do not invest in mark to market instruments and hence carry no interest rate risk.

In the current scenario, floating rate funds have become popular because global interest rates seem to have hit a trough and major Central Banks around the world are seen raising interest rates, a need is felt for a product that can take advantage of the upward movement in interest rates.

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Also, with the possibility of upward movement in the yield curve (the relationship between tenure of a bond and its interest rate), there has emerged a differentiation between short term floating rate funds and long term floating rate funds.

The Short Term Floating Rate Funds currently available in the market are positioned to take advantage of movements in the shorter end of the yield curve.

They do so through investing in floating rate instruments linked to shorter term benchmarks like the MIBOR (Mumbai Interbank Offered Rate) by creating synthetic instruments through executing swap positions of a tenor of 6 months or below and hence are ideal for investors who desire to execute positions at the shorter end of the yield curve.

Also it is relatively stable being largely a function of policy rates and the prevailing liquidity condition in the system. The recommended minimum investment horizon for this product is one day.

Under current circumstances when the yield curve is expected to shift upwards at the longer end, the objective of the Long Term Floating Rate Funds is to deliver optimal returns by positioning itself on the longer end of the yield curve.

Given that the yield curve is positively sloping and is likely to get further steep given the general undertone in the market, the long-term plans deliver on two counts:

• Higher accrual income
• Capturing basis (interest rate) movement through steepening of the curve without taking unhedged mark-to-market positions. (For example, if you have a 3-year fixed rate bond in our portfolio. You execute a swap position against this 3-year bond wherein you pay a fixed rate and receive a floating rate against it. This amounts to hedging of mark to market position.)

Accordingly, the long-term floaters invest in:

• Long and short floating rate bonds with coupon linked to diversified set of benchmarks (MIBOR, INBMK)
• Other long and short fixed rate debt securities converting to synthetic floating through swaps (relatively longer tenor OIS swaps and INBMK Swaps)
• Fixed-income debt securities and money market securities or instruments.

Given the higher potential movement in this area of the yield curve, there may be a little volatility in the return profile of the long-term floaters, though over the intended investment horizon of the product is likely to give superior returns.

So the next time you want to convert your floating rate home loan to fixed, do the reverse and shift your investments from fixed rate debt fund to a floating rate debt fund.

The author is Head-Investments at Standard Chartered AMC. The views expressed in this article are of the author.