Key Takeaways
- Invests in bonds with variable interest rates.
- Yields rise with benchmark interest rates.
- Less sensitive to interest rate hikes.
- Carries credit and liquidity risks.
What is Floating Rate Fund?
A floating rate fund is a fixed-income mutual fund that invests primarily in securities with interest rates that adjust periodically based on benchmarks such as the RBI repo rate. These funds aim to reduce interest rate risk by holding instruments whose yields fluctuate with market rates, unlike traditional fixed-rate bonds.
This type of fund often includes adjustable instruments like bank loans or bonds with variable coupons, providing a hedge against rising interest rates. You can compare floating rate funds to other fixed-income options to see how they fit within your portfolio.
Key Characteristics
Floating rate funds possess unique features that differentiate them from other bond funds:
- Variable Interest Rates: The fund holds securities with coupons that reset periodically, helping maintain yield during rate hikes.
- Lower Interest Rate Sensitivity: Prices are more stable compared to fixed-rate bonds, mitigating interest rate risk.
- Diversified Holdings: Investments include floating-rate bonds, senior bank loans, and sometimes securitized loans.
- Income Focus: Distributes regular income, suitable for investors seeking steady cash flow.
- Credit Exposure: May involve below-investment-grade loans, introducing credit risk considerations.
- Liquidity Constraints: Some underlying assets can be illiquid, affecting trading flexibility.
How It Works
Floating rate funds allocate a significant portion of their assets to securities with coupons tied to short-term benchmarks. When benchmark rates rise, the interest payments on these instruments increase, boosting the fund’s yield and net asset value.
Fund managers actively select loans or bonds that reset periodically, often quarterly, which helps maintain income levels in rising rate environments. However, if rates decline, these funds may underperform fixed-rate alternatives due to falling yields. Understanding the dynamics of adjustable instruments such as callable bonds can provide insight into fund behavior.
Examples and Use Cases
Floating rate funds are particularly useful for investors aiming to protect income against rising interest rates or seeking diversification in fixed income.
- Airlines: Companies like Delta may issue floating rate debt tied to benchmark rates to manage borrowing costs.
- Bank Loan Funds: These funds invest in senior loans to lower-credit companies, capturing higher yields when rates climb.
- Income-Oriented Portfolios: Investors combine floating rate funds with other assets, including those highlighted in our best bond ETFs guide, for balanced income strategies.
Important Considerations
While floating rate funds offer protection against rising rates, they come with risks such as credit exposure and potential liquidity challenges. You should evaluate the credit quality of underlying loans and the fund’s strategy carefully.
Additionally, in periods of falling rates, floating rate funds may deliver lower returns compared to fixed-rate bonds. Consider how these funds complement other holdings, including those featured in our best ETFs selections, to optimize your portfolio’s risk-return profile.
Final Words
Floating rate funds offer a way to mitigate interest rate risk by adjusting yields with market rates, making them suitable when rates are rising. To evaluate if they fit your portfolio, compare yields and fees across funds and consider how they align with your income needs and risk tolerance.
Frequently Asked Questions
A floating rate fund is a type of mutual fund that invests primarily in debt securities with variable interest rates that adjust periodically based on benchmarks like the RBI repo rate or other short-term rates. These funds aim to reduce sensitivity to interest rate changes by having returns that fluctuate with market rates.
Floating rate funds allocate at least 65% of their assets to instruments with interest rates that reset periodically, such as floating-rate bonds or senior bank loans. When benchmark rates rise, the fund’s yields and NAV tend to increase, while falling rates can reduce returns.
These funds help mitigate interest rate risk since their yields adjust with market rates, making them attractive during rising rate environments. They also offer diversification with low correlation to equities and traditional fixed income, plus regular income distributions for investors.
Yes, floating rate funds carry credit risk due to exposure to lower-rated corporate loans, and they can underperform when interest rates fall. Additionally, liquidity risk exists because underlying loans may trade infrequently, causing price volatility or delays in interest rate resets.
Floating rate funds tend to outperform fixed-rate bonds during periods of rising interest rates because their coupon payments adjust upward. However, in stable or declining rate environments, they may underperform fixed-rate bonds since their yields decrease with benchmarks.
They invest in floating-rate bonds, senior bank loans to lower-credit companies, and securitized loans like mortgage-backed securities. These assets have interest rates that reset periodically based on a short-term benchmark rate.
Investors seeking to reduce interest rate risk and earn regular income during periods of rising rates may find floating rate funds appealing. However, those sensitive to credit risk or seeking stable returns in falling rate environments should evaluate the risks carefully.
