Is your debt fund loading up on floating rate bonds?

The risk here is not of default, but of liquidity and mis-pricing. According to the above officials, the trading in such bonds is few hundred crores on day to day basis. “FRBs can, at times, be liquid and prone to significant fluctuations in prices. Also, since the outstanding size of FRBs has only increased in the recent past, it is difficult to ascertain how they will behave under the change in monetary policy,” said Sandeep Yadav, head-fixed income, DSP Investment Managers. “The major risk with FRBs is liquidity, which can sometimes lead to inaccurate pricing. This is especially true when the majority of participants tend to be on one side of the market.”

When investors buy debt mutual funds, they usually look at a measure called ‘modified duration’. This metric tells you about the change in the value of a fund’s portfolio in response to a percentage increase in interest rates. For example, if the revised period is 3 and interest rates rise by 1%, the fund’s NAV (net asset value) will fall by 3%. However, FRB is an anomaly. Their modified duration is short because their interest is tied to a convertible benchmark, which can give investors a false sense of comfort. However, their actual maturity, especially for government bonds, is much higher, around 10-12 years. “The price of a floating rate bond is linked to two things. The first is an external benchmark like the repo rate or the 3-month treasury bill yield. The second is the spread on that produce. This spread now faces mark-to-market changes that are linked to the actual maturity of the bond which could be 10 years away,” said a senior industry executive, who declined to be named.

At present, approx 4.3 trillion government FRBs are outstanding, most of which are with banks. According to the head of fixed income at a major fund house, the government also finds FRBs a convenient way of managing its debt. Instead of issuing short-term paper, which often matures, forcing the government to borrow again, an FRB has a long-term maturity. The government only needs to pay a convertible coupon. Banks buy these bonds because they have long-term assets like home loans, which also have variable interest rates.

in addition to the following 51,000 crore exposure to government FRBs, also a part of mutual fund industry 24,000 crore exposure in corporate FRBs.

Fund houses are sharply divided on their perception of FRBs. “In a scenario where the interest rate cycle is bottom to bottom and the central bank wants to push rates higher, investors become wary of investing in fixed rate bonds and FRBs become a natural choice for investors. Interest rates have not started raising and investor preference for FRBs through rising rate cycles remains positive. The current spread of FRBs issued by Government of India in 2031-34 is currently between 80-110 bps in primary auctions/switches which is attractive from a historical perspective and relative to other risk spreads in the market,” said Manish Banthia, Senior Fund Manager at ICICI Prudential Asset Management Company.

“The bid cover ratio in the auction which reflects investor interest has been very strong. In the last auction held on November 18, the bid cover ratio was more than 3 times. The demand from market participants is so high that the Government of India has been issuing FRBs in monthly auctions. The last two months saw a demand for approx. 40,000 crore in FRB from investors in switch auction. With such a huge amount of demand and participation from all kinds of investors, the question of wrong pricing and liquidity is wrong. The mutual fund holding of FRBs issued by Government of India is just 10% and banks continue to be the largest holders of FRBs issued by Government of India.”

“Market implied spreads are largely a function of market expectations on rates as well as near-term demand and supply. In the near future, spreads may change due to other market movements. For example, in October, the RBI announced a major switch 36,000 crores entirely in FRB as opposed to normal switch of (conversion of small fixed rate government securities to FRB) 6,000 crore in FRB. This led to price volatility in the FRB, causing the implicit spread in the market to rise from 100 bps to 105 bps. At the same time, index based, i.e. 6-month bills have risen from 3.40% to around 3.81%, leading to higher accumulation in the recent past,” said Rajiv Radhakrishnan, head of fixed income at SBI Mutual Fund.

Investors should watch out for large mismatches between the revised tenors and the average maturity of their debt mutual funds, especially in categories like short duration or short duration. “Investors should be aware that FRBs are significantly more volatile than similar duration papers. Generally, the greater the difference between maturity and tenor, the higher is the volatility,” said Yadav of DSP Mutual Fund.

If there is no such mismatch, talk to a financial advisor to understand why and to what extent floating rate bonds are present in the portfolio.