Prime Recommendation: 2 floating rate debt funds for medium time frames

With interest rates being where they are – i.e., stable with no clear signs of a move upwards or downwards – you would wonder where you could hold investments meant for a 2-3 year timeframe. And many of you also wonder if the best option you have is to go for floating rate debt funds as they would have an edge over other debt fund categories. Here’s answering those questions.

What floating rate funds do

By definition, a floating rate debt fund would invest in debt instruments where interest rates are linked to benchmark market rates – so if rates go up, interest earned would automatically rise and vice versa.

In reality, though, there are few floating-rate instruments available in the market today. Floating rate funds are mandated to hold at least 65% of their portfolio in floating-rate instruments. With the dearth of such instruments, what funds do instead is to hold derivative instruments that are a proxy to the floating concept.

These derivative instruments include, one, interest rate swaps – where payments on a fixed-rate instrument are swapped for floating-rate payments linked to benchmark rates. So, if a fund exchanges a fixed-rate payment for a floating one, it automatically benefits if rates rise. To this extent, it is a call on direction of interest rates as a falling rate would leave the floating-rate instrument at a disadvantage. Funds also use forward rate agreements, where two parties exchange interest payments for a specified period in the future and interest rate futures to counter their fixed-interest rate risk.

However, while floating rate debt funds offer some hedge to interest rate risk, note the following points:

• They do not shield you from volatility or duration risk. SEBI categorization does not specify what maturity a floating rate fund needs to have. Therefore, funds with short-term instruments or those that have a higher share of money-market instruments tend to be less volatile than other floating rate funds. Based on 1-month rolling returns for a 3-year period, the lowest return funds delivered ranged from a 2.2% loss to a 0.4% gain.
• Because of such differences in maturity profiles and portfolios, funds can deliver losses in periods such as a week or month. This is par for the course. The proportion of times these funds delivered losses on a 1-month basis in the past 3 years averaged about 6%.
• The absence of maturity definitions mean that funds can shift their average maturities based on prospects – that is, they may move from an average maturity of less than a year to 2-3 years or more. Therefore, these funds are best used for timeframes of longer than 1 year to avoid surprises on the duration front.

Therefore, while floating rate debt funds are a good choice in uncertain markets such as the present one, you need to be careful in knowing the nature of the fund you are going for.

In Prime Funds, as many of you already know, we go by the minimum holding period required when recommending funds and not the category. We already have a floating rate debt fund that we covered for time frames of 3 months to 1.5 years. For a timeframe of 1.5 years – 3 years, our recommended list features the two funds below.

HDFC Floating Rate Debt

HDFC Floating Rate’s average 2-year return over a 5-year period works out to 7.9%. The average for comparable categories of floating rate, short-duration, and money-market funds is 7.31%. 3-year returns also hold at similar performance levels.

But the fund has been improving performance in recent times.  Consider the 2-year rolling return from 2018 onwards. The margin by which the fund outperforms the category average over this period has been rising. In 2018, for example, the fund’s rolling 2-year return beat the category average by less than 1 percentage point. This margin gradually expanded to around 1.5 percentage points.

In terms of consistency too, HDFC Floating Rate scores well; across 1-year, 2-year and 3-year timeframes, the fund beat the average of the categories mentioned above almost all the time.

HDFC Floating Rate is also low on volatility – primarily from the CP/CD laden low maturity portfolio it was sporting earlier. The proportion of times it slid into losses on a weekly or monthly basis over the past 3 years is 8% and 3% - less than most funds in the categories mentioned above. Its worst 1-month return of a 1.1% loss is better than even ABSL Floating Rate, the other top performer in the floating rate category.

HDFC Floating Rate is among those that shift portfolio maturities based on markets. The fund has run an average maturity of 2+ years from July 2020, which has crept higher to 3 years currently. The fund has run at less than 1 year maturity in the months before that.

The fund holds a mix of money market instruments such as CPs and CDs; share of these were at just under half the portfolio in earlier months of 2018-2019 but has now dropped to a fifth of the portfolio. It instead upped holdings in corporate debt and gilt instruments. The share of derivatives in the portfolio changes from month-to-month; its current portfolio has about 46% held in derivatives.

HDFC Floating Rate holds a degree of credit risk. Share of papers rated AA and lower stands at about 10% of the portfolio currently; it has been higher at 15% in earlier months. These relatively low-rated papers are a mix of bank perpetual bonds and papers from NBFCs such as Manappuram Finance and Tata Motors Finance.

Given where interest rates are, portfolio YTMs are obviously not high – April portfolio YTM stands at 5.01%. But this is, in fact, an improvement. YTMs were as low as 4.81% in November 2020. However, YTMs in floating rate funds are not a direct measure of the returns, given the derivative exposure and the swaps the funds use, besides portfolio changes. HDFC Floating Rate’s actual returns has run well ahead of portfolio YTMs before; for example, it had an average portfolio maturity of just below 1 year in January 2020 with a YTM of 6.2%; 1-year returns since January this year have been above 7.5%.

Suitability

Given the fluctuations in average maturity and the presence of credit risk, HDFC Floating Rate Debt can be used as follows:

• For portfolios with at least 2-year timeframes. Combine it with nil-credit risk funds from ultra short/ low duration categories if your horizon is short; do not let it be the only fund you hold for such periods. If you’re looking at timeframes longer than 3 years, HDFC Floating Rate can be used along with longer-maturity corporate bond, medium duration or gilt funds (or those that we’ve recommended in the Medium Term and Long Term categories in Prime Funds).
• For those with a lower-risk appetite, this fund is best avoided if timeframes are less than 3 years. Go for funds with no credit risk and shorter-maturity in the ultra short/low duration/ money market categories – again, Prime Funds will list these for you.

Nippon India Floating Rate Debt

This is another fund that has stepped up performance in the past two years. From beating the category average (same categories as mentioned above) by less than 1 percentage point before 2020, the fund has improved performance to beat the category by close to 2 percentage points now, when considering 3-year return. Performance improvement has shown up even stronger in shorter-term periods.

This is partly to do with smart rate direction calls by the fund; it stepped up allocation to gilt instruments of different maturities and rode last year’s bond price rally well. Gilt exposure jumped to about a fifth of the portfolio over the course of 2020; derivatives on gilt instruments are also more common. This apart, the fund has also increased holding in SDLs, which can offer better coupon for lower risk.

Given the gilt exposure, though, the fund’s YTM is lower than HDFC Floating Rate at 4.84% in its April 2021 portfolio. This level, however, is still better than many other short-duration funds and is on par with the floating rate category.

Nippon Floating Rate does not hold much in money market instruments; its average maturity tends to be 2 years or longer most of the time. However, it takes no credit risk. Its entire portfolio is held either in AAA-rated papers, SDLs, or gilts. The fund primarily uses interest rate swaps to build its floating exposure.

The longer maturity and the gilt presence, however, also lead to volatility. Nippon Floating Rate tends see much bigger swings in short-term returns compared to other funds. It sees a higher loss frequency as well; rolling its 1-month returns over a 3-year period has seen it dip into losses about 9% of the time – a level that’s similar to short-duration funds and far higher than other floating rate funds. This evens out over time, though; on a 1-year basis, the fund’s volatility is much lower than short-duration funds.

Suitability

Because Nippon India Floating Rate has a longer portfolio maturity and higher volatility, it needs to be held for at least 2 years. Do note that it can be more volatile than HDFC Floating Rate over shorter time frames and therefore suitable only if you can take more volatility. As with HDFC Floating Rate, pair this fund with lower-volatile, lower-maturity funds (refer the 3 months – 1.5-year section in Prime Funds) if your timeframe is 2-4 years. If you’re looking at longer timeframes, this fund can be used to form the debt component of your portfolio.