Floating Rate Bond Funds: Types, Features, and Benefits

A floating rate debt fund is a type of debt fund that primarily invests over 65% of its overall assets in floating rate instruments. These floating rate instruments can include corporate bonds, collateralized debt such as loans from companies that have variable or floating interest rates. Unlike fixed-rate instruments, floater funds do not have a predetermined coupon rate, so their returns can vary over time.

The interest rate of floating rate bond funds is primarily determined by fluctuating interest rates in the market. Any changes in the repo rate set by the Reserve Bank of India (RBI) can also impact the returns of these debt instruments. Each floating rate instrument is associated with a specific benchmark, and as the benchmark rate changes, the interest rate of these financial instruments changes accordingly.

When the market lending rate like repo rate surges, the interest rate of floating floater funds also rises, leading to higher returns reflected in the Net Asset Value (NAV) units of these funds. Consequently, these funds aim to capitalise on the opportunity presented by fluctuating interest rates.

As companies observe an increase in repo rates, they tend to raise the interest rates on their debt securities to create significant demand in the market. This becomes necessary because individuals tend to favour government securities when repo rates rise, as they offer comparatively higher returns. As a result, the demand for debt instruments issued by listed companies, such as bonds in India, decreases, leading to a decline in their market prices.

To address this situation and ensure sufficient cash flow for their operational costs, businesses opt to issue debt securities with variable return rates. By offering these securities with variable interest rates, companies can gather the necessary funds despite the changing market conditions caused by fluctuating repo rates. Thus, Investors may choose to invest in these funds when interest rates are surging in the country.

Floater funds can be categorised into two types:

Floating rate bond funds have several features and benefits. Find about them below:

The main limitation of investments in a floating rate bond fund is its heavy reliance on current market conditions. Returns received from these funds are highly influenced by changes in repo rates, which are determined by the RBI based on the country's current economic situation. As a result, it becomes challenging to predict the returns from floater debt securities in advance, thus increasing the risk associated with these investments.

For floating rate bond funds, any short-term or long-term capital gains offered from the sale of securities are subject to taxation rules of mutual funds designated as non-equity schemes. If the fund is held for a duration less than three years, short-term capital gains tax (STCG) is applicable based on the individual's income tax slab.