Thread by @ETMONEY

It was evident. Interest rates would rise as #inflation started spiralling.

To ride through the rate hike cycle⬆️, #FloaterFunds were touted as an ideal #investment option.

But, so far, they haven’t done well.

A 🧵on why #FloatingRateFunds haven’t delivered yet.

First, some basics.

When #InterestRates rise📈, bond #prices fall📉. Why? Investors would rather buy new papers at a higher rate than old ones with lower yields.

#FloaterFunds are not impacted by interest rate movement. There’s a simple explanation.👇

As the #InterestRates rise, the yields on floating-rate bonds also increase.⬆️

So, #investors don’t need to sell them to buy new papers offering higher interest rates.

But the converse is true, too. So, when interest rates fall📉, #FloaterFunds become unattractive.

But after RBI hikes #RepoRate in May and June, there has been no jump in returns from #FloaterFunds.

In comparison, other short-duration debt funds have done better in the short term (see table).

Let’s understand the reasons.👇

In India, the size of the #FloatingRate bond market is very small.

There are not enough bonds available for these #funds to invest in.

So, these funds use a complex legal method to get convert the fixed-rate bonds into floating-rate papers

Here’s what they do.👇

They use derivative instruments like Interest Rate Swaps.

In this, two parties get into an agreement. Whoever benefits from the #InterestRate movement, will compensate the other party. The payment is made at regular intervals like quarterly or yearly.💰

So, the first reason for under-performance is that the dates on which one party compensates the other is still some days away.

Once the #FloaterFunds get their payment from their derivatives contract, their #returns could start to rise.📈

Let’s now look at the other reason.👇

#FloaterFunds can park up to 35% of the corpus in traditional fixed-rate bonds.

This portion of the #portfolio can impact overall returns based on its performance.

If a fund held medium to long-term bonds, the #returns would have taken a hit when interest rates rose.📈

If you look at past performance of #FloaterFunds, they have usually performed well in rising⬆️ #InterestRate scenarios.

The largest scheme, HDFC Floating Rate Debt Fund, had its best returns (10.35%) between Aug 2013 and Aug-2014, when #RepoRate peaked at 8% in the past decade.

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