Let your investments float. . .

Floating rate instruments have been in the news lately as debt markets continue to witness one of their most volatile phases.

Over the past few weeks, most plain vanilla long-term debt funds have witnessed a fall while floating rate funds provided the saving grace and sustained investor portfolios.

Very few investors realise this, but floating rate funds have been a face-saving option for most of 2003, when debt markets have been hit hard by interest rate volatility.

Volatility, the bane of equity markets, is something that is widely accepted by investors as an investment hazard.

However, on the debt side, investors haven't got 'conditioned' to dealing with interest rate volatility until the recent past.

In fact, volatility in debt funds has come as a rude shock to most risk-averse investors and runs contrary to their 'view' on debt funds, which is one of stability and consistency.

First lets understand how fixed rate instruments contribute to volatility. Typically, the benchmark bond yield (e.g. 7.27% GOI yield) tells investors how the debt market is performing.

The bond yield in turn depends on the coupon rate (which is fixed) and the market price, which changes everyday as these instruments are traded on a daily basis.

So the yield adjusts on a daily basis depending on the market price of the instrument. If the market price of the fixed rate instrument climbs, then the yield would fall.

If the market price falls, then the yield would rise. This is the inverse relationship between bond prices and bond yields.

Frequent rise and fall in the 'bond yield' leads to volatility in debt markets. Since plain vanilla debt funds invest in fixed rate instruments they bear the brunt of the volatility, whenever it rears its head.

Having understood how fixed rate instruments contribute to volatility it gets a little easy to understand how floating rate instruments try to curb it.

In a fixed rate instrument, the coupon rate does not change throughout the tenor of the instrument.

This puts added 'pressure' on the bond price to determine the yield. In a floating rate instrument, the coupon rate is not fixed; rather it is benchmarked against a market-driven rate like the Mumbai Interbank Offered Rate (MIBOR), for instance.

The coupon rate on a floating rate instrument is adjusted to the benchmark rate -- lets say the MIBOR. So every time the MIBOR fluctuates, the coupon rate on the instrument is adjusted accordingly.

That is why the coupon rate is referred to as 'floating rate'. Notice how in this setup, the yield changes with the fluctuation in the MIBOR (which is adjusted twice a year) and not the market price of the instrument.

As the market price plays a diminishing role in a floating rate instrument, there is lower volatility on a day-to-day basis, which is a regular feature with a fixed rate instrument.

Floating rate funds invest largely in floating rate instruments and fixed rate corporate bonds. They are better 'designed' to counter volatility and mitigate risk arising from interest rate fluctuations.

This has actually translated into growth for debt fund investors in times of volatility, which has afflicted debt markets several times this year, the current scenario being a case in point.

Let it 'float'…

Floating rate funds have given investors a positive return over the last month, which was marked by volatility in bond prices.

Debt funds (investing in fixed rate instruments) on the other hand had to bear the brunt of the volatility, which reflects in their returns.

To strike some kind of parity we have taken fixed and floating rate schemes from the same fund house.

This should give investors an idea of how differently siblings from within the same fund have performed over the same time-frame (1-month in our example).

'Fixed rate' spells volatility

Floating rate funds strive to fulfill their role as a stabilising force in debt portfolios. As Nilesh Shah (CIO -- Debt, Franklin Templeton Investments) put it, 'It (the floating rate fund) is ideally suitable for people who want a stable rate of return without any volatility.

This fund could also be an ideal investment option especially in a rising interest rate scenario.'

A floating rate income fund had become something of a necessity with a definite role to play in the future in view of increasing volatility in debt markets.

Investors need to understand this and make adjustments going forward.