Understanding Floater Funds: Types, Risks & Portfolio Benefits

When it comes to investing in debt mutual funds, floater funds are a good option to consider. Floater mutual funds primarily invest in debt instruments with variable interest rates, aiming to offer investors protection against increasing interest rates, as their returns fluctuate based on market conditions.

Read on to understand the concept of floater funds, the different types available, the risk-reward dynamics involved, and whether they should be part of your investment portfolio.

Floater fund meaning

A floater fund is a type of debt mutual fund that invests predominantly in floating rate instruments, such as bonds and loans, where the interest rates fluctuate based on a benchmark rate like the Reserve Bank of India's (RBI) repo rate.

According to regulations set by the Securities and Exchange Board of India (SEBI), at least 65% of a floater fund's total assets must be invested in floating rate instruments. This characteristic allows floater funds to respond dynamically to changes in interest rates, making them an attractive option for investors seeking to mitigate interest rate risk.

Types of floater funds

Floater funds can be broadly categorised into two types:

• Short-term floater funds: These funds primarily invest in short-term debt securities such as treasury bills, certificates of deposit, and government securities. They typically have maturities of less than one year and are designed for investors looking for liquidity and lower risk.
  

• Long-term floater funds: As the name suggests, these funds invest in long-term debt securities with longer maturities. They may include corporate bonds and government bonds with floating interest rates. While they offer potentially higher returns due to longer durations, they also come with increased exposure to interest rate fluctuations.
  

Understanding the risk-reward scale of floater funds

Here is what you need to know about the risk-reward scale of floater funds:

• Lower interest rate risk: One of the primary advantages of floater funds is their reduced sensitivity to rising interest rates compared to fixed-rate debt instruments. When interest rates increase, the returns from floating rate instruments also rise, providing a buffer against capital loss that typically affects fixed-rate bonds.
  

• Potential for higher returns: In a rising interest rate environment, floater funds can offer attractive returns. Their ability to adjust yields according to market conditions allows floater funds to capitalise on favourable shifts in interest rates.
  

• Credit risk: While floater funds generally carry lower risk than equity investments, they are not devoid of risks. Some funds may include corporate bonds with low credit ratings that are close to junk status or loans with default risk. As an investor, you should carefully evaluate the credit quality of the fund's portfolio before investing.
  

• Market volatility: The performance of floater funds can vary based on market conditions. If interest rates stabilise or decline, returns may not be as favourable compared to fixed-rate investments. Therefore, while floater funds can provide stability during rising interest rates, they may underperform in a declining rate environment.
  

Should floater funds be in your portfolio?

Your financial goals and risk tolerance lay an important role in determining whether you invest in floater funds. These funds can be suitable for:

• Conservative investors: If you have a low risk appetite but want exposure to debt markets, floater funds can be an appealing choice. They offer a balance between generating income and preserving capital while minimising exposure to rising interest rates.
  

• Diversification: Floater funds can enhance portfolio diversification by adding a different risk-return profile compared to traditional fixed-income investments or equities. They can serve as a stabilising component within a broader investment strategy.
  

• Market outlook consideration: You should consider economic indicators and forecasts regarding interest rate movements before allocating significant portions of your portfolio to floater funds. If rising interest rates are anticipated, these funds could be particularly beneficial; conversely, if rates are expected to decline or remain stable, other fixed-income options might be more suitable.
  

How to choose the right floater fund?

Consider the following factors when investing in a floater fund:

1. Portfolio composition: Look for funds that allocate the majority of their investments to high-quality floating-rate instruments. A mix of government securities and AAA-rated corporate bonds can minimise credit risk.
   
2. Historical performance: While past performance is not indicative of future returns, analysing a fund’s performance across different interest rate cycles can provide valuable insights.
   
3. Expense ratio: A lower expense ratio ensures that a greater portion of the returns is passed on to you, making it an important factor in fund selection.
   
4. Fund manager expertise: A skilled fund manager can make a significant difference by navigating interest rate cycles effectively and optimising returns.
   
5. Investment objective alignment: Ensure the fund’s objective aligns with your financial goals and risk appetite.
   

Read More: About Kotak Floating Rate Fund

To sum up

If you are an investor who wants to manage shifting interest rate environments and seek modest returns with fewer risks than stocks, floater funds offer a smart option. They can contribute significantly to the diversification of your investment portfolio because of their special structure, which permits flexibility in responding to market conditions.

Making wise investment decisions requires knowing the various types of floater funds, such as short-term and long-term, and evaluating their risk-reward characteristics. In the end, your personal financial goals and the state of the market will determine whether you should incorporate floater mutual funds in your portfolio.