Floating Rate Funds: Understanding & Investing in Variable Interest Rates

A floating rate fund is a type of mutual fund that invests in securities paying fluctuating interest rates. Floating rate funds primarily invest in debt instrumentsDebt InstrumentA debt instrument is a fixed-income asset that legally obligates the debtor to provide the lender interest and principal payments like loans and bonds. The fluctuation in rates of interest generates worthy returns for investors.

Each financial instrument that the floating rate fund invests in follows a certain benchmark. The changes in the related benchmark’s rate cause the interest rates of the financial instruments to change.

For example, an increase in the interest rates in the debt market will result in a rise in the returns from floating rate funds. Thus, floating rate funds are aimed at providing flexible interest incomes to investors in a world of rising interest rates.

Summary

• A category of mutual fund that invests in securities paying fluctuating interest rates is called the floating rate fund.
• A floating rate fund is less sensitive to interest rate variations compared to an instrument having a fixed rate of payment or a fixed coupon rate.
• Floating rate funds are secure investment options that also provide quality returns. Hence, these funds are suitable for investors who are reluctant to take risks.

Understanding the Floating Rate Fund

A floating rate fund is less sensitive to variations in the rate of interest compared to an instrument with a fixed rate of payment or a fixed coupon rateCoupon RateA coupon rate is the amount of annual interest income paid to a bondholder, based on the face value of the bond.. Floating rate funds attract investors when the interest rates are rising since they will provide higher coupon payments or interest income.

A floating rate fund contains various types of variable rate debts, including loans. The objectives of managing these funds are similar to credit funds and vary with the type of funds. The interest rates on variable-rate instruments in the floating rate funds are adjusted to a given level.

Portfolio managers manage the income paid from the investment of a floating rate fund, and shareholders receive the income via regular distributions. The distributions can include capital gains and income, which may be paid annually, semi-annually, or quarterly.

Floating Rate Fund Types

1. Short-term Floating Rate Fund

The funds are invested in debt instruments with high liquidity and short-term maturity periods, such as government securities and T-bills.

2. Long-term Floating Rate Fund

The funds are invested in debt instruments with long-term maturity periods. While long-term floating rate funds are primarily invested in floating rate instruments, a part of the funds is invested in the money marketMoney MarketThe money market is an organized exchange market where participants can lend and borrow short-term, high-quality debt securities. or fixed floating rate instruments.

Features of a Floating Rate Fund

1. Diversified Portfolio

Since floating rate funds invest a greater number of assets in instruments with varying rates, they yield worthy returns during periods of favorable interest rates. The remaining funds are invested in securities offering fixed interest income. Such diversification in a portfolio leads to quality returns in the long-term.

2. Less Risk

Floating rate funds are secure investment options and also provide quality returns. Hence, the funds are suitable for investors who are reluctant to take risks. Although floating rate funds are more secure investment options than equity funds, there is credit risk associated with them.

When bond issuers fail to make repayments, credit risk arises. Hence, investors should invest in floating rate funds with securities that come with high credit ratings.

3. High Returns

The returns of a floating rate fund in the long-term are higher than that of fixed deposits and other debt instruments. When investors expected interest rates to rise in the debt market, the opportunity to earn high returns should be leveraged through investments in floating rate funds.

4. Taxation Policy

A floating rate fund is taxed in the same way as a debt mutual fund. If the holding period is less than three years, investors are taxed a short-term capital gain at a rate that depends on the income of the investors. If the holding period of an investment is greater than three years, investors are charged a long-term capital gain tax.

5. Open-ended Schemes

Floating rate funds allow investors to invest in securities according to their financial objectives, needs, and investment time horizon.

Related Readings

CFI is the official provider of the Commercial Banking & Credit Analyst (CBCA)™Program Page - CBCAGet CFI's CBCA™ certification and become a Commercial Banking & Credit Analyst. Enroll and advance your career with our certification programs and courses. certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

• Credit RiskCredit RiskCredit risk is the risk of loss that may occur from the failure of any party to abide by the terms and conditions of any financial contract, principally,
• Investment HorizonInvestment HorizonInvestment horizon is a term used to identify the length of time an investor is aiming to maintain their portfolio before selling their securities for a profit. An individual’s investment horizon is affected by several different factors. However, the primary determining factor is often the amount of risk that the investor
• Floating Interest RateFloating Interest RateA floating interest rate refers to a variable interest rate that changes over the duration of the debt obligation. It is the opposite of a fixed rate.
• Variable-Rate MortgageVariable-Rate MortgageA variable-rate mortgage is also known as an adjustable-rate mortgage (ARM). It refers to a type of home loan where the interest payment is not fixed but