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The interest rate
The interest rate yo-yo has impacted most of us. Interest rates have been volatile in the past few years. Riding this Interest rate roller-coaster can be a nerve-racking experience. At times enjoyable and at times distressing. In times when interest rates were going down, one benefited from cheaper loans but lost out on lower returns on investments. Conversely when interest rates stiffened, one benefited from higher rates on fixed rate investments but lost out on dearer loans.
Understanding Fixed Rate Loans and Floating Rate Loans
Before actually trying to unravel Floating Rate Instruments, let us get a grip on a situation we are familiar with - Floating rate and Fixed rate loans.
A fixed interest rate loan has the advantage of clearly defining the total loan obligation, but in case of a fall in interest rates, a fixed rate loan may result in a higher debt service obligation. On the other hand, a floating rate loan allows you to take advantage of interest rate movements. The interest rate in such loans is linked to a benchmark generally the internal prime- lending rate. This is adjusted periodically in relation to market movements.
Thus a floating rate loan denies you the knowledge of the total loan obligation but ensures that you reap benefits in case of fall in interest rates. So quite clearly floating rate loans work best to your advantage at time when interest rates are falling.
Quite similarly a Floating Rate instrument is a debt instrument whose interest rate (coupon) is not fixed and is linked to a benchmark rate and is adjusted periodically.
What is a benchmark rate?
A benchmark or a reference rate is a rate that is an accurate measure of the market price. In the fixed income market, it is an interest rate that the market respects and closely watches. A benchmark rate should be from an unbiased source, be representative of the market, transparent, reliable and continuously available and most importantly be widely acceptable to the market as the benchmark rate
Such benchmark rates issued by unbiased sources are the Treasury Bill T-Bill) rate issued by the Government of India, the bank rate as decided by the Reserve Bank of India, the Mumbai Interbank Offering Rate (MIBOR) released by the National Stock Exchange of India and GOI Securities.
A company issues debentures at 1 year GOI Security yield +100 basis points (simply 1%) with a tenor of 5 years, periodically reset every six months. If the1 year GOI security is currently ruling at 5.75%, the interest rate that is fixed for the first six months is 5.75% +1%=6.75%.
What are Floating Rate funds?
A floating rate fund is a fund that by its investments in floating rate instruments seeks to provide stable returns with low level of interest rate risk and volatility. For example the UBS Floating Rate Fund invests primarily in
- Floating rate debentures and bonds
- Short tenor fixed rate instruments
- Long tenor fixed rate instrument swapped to floating rate (Interest Rate Swaps)
Why Floating Rate Funds?
Floating Rate funds are protective funds and shield your investments from interest rate fluctuations.
In a declining interest rate scenario older securities issued at higher coupon rates (interest paid on the face value of a debt instrument) appear much more attractive than the ones that are currently issued. Consequently older higher interest bearing securities would go at a premium. Thus long term income funds by virtue of their investments in longer maturing securities would see a rise in their Net Asset Values.
However, when interest rates are on the rise newer securities appear more attractive than the ones that were issued earlier, as they offer higher coupons than their predecessors. The lesser paying older securities therefore will be sold at a discount. So the same income fund with a majority of investment in longer maturing securities, now start earning you lesser as newer securities continue to earn higher returns than the ones in the portfolio.
This bearish scenario lasts as long as interest rates continue to show an upward trend. It is during these times that floating rate funds offer the best utility.
In a rising interest rate scenario, the interest rate on a Floating Rate instrument is periodically reset to a higher level due to the fact that accompanying benchmark rate is anyway at a higher level. On account of this periodic reset the difference in returns between a floating rate fund and a security that is issued currently is marginal. So the price difference is marginal leading to a marginal impact on the NAV.
Interest Rate Swaps
Most floating rate funds also invest in something referred to as 'Long tenor fixed rate instrument' swapped to floating rates. These kinds of instruments are commonly referred to as an Interest Rate Swaps. By definition an interest rate swap is a contractual agreement entered into between two counter parties under which each agrees to make periodic payment to the other for an agreed period of time based upon a notional amount of principal. The principal amount is notional because there is no need to exchange actual amounts of principal.
A fixed for floating interest rate swap is an exchange of a series of fixed interest payments for a series of floating interest payments, fluctuating with the benchmark.
Example
Fund A and Bank B enter into an IRS agreement where in Fund A pays Bank B a fixed rate of 7.25%p.a. for three months and receives NSE MIBOR (benchmark floating rate) from Bank A for the next 3 months on a notional principal of Rs. 10 Cr.
Scenario I
After 3 months let us assume the average MIBOR compounded daily turns to be 7.05% p.a.
Fund A would pay = 10,00,00,000 x (7.25/100) x (90/365) = 17,87,671
Bank B would pay = 10,00,00,000 x (7.05/100) x (90/365) = 17,38,356
Net Pay from Fund A to Bank B = Rs. 49,315
At the end of 3 months SCMF would pay Bank A Rs. 49,315. Please note that the notional principal is not exchanged.
Scenario II
After 3 months let us assume the average MIBOR compounded daily turns to be 7.45% p.a.
Fund A would pay = 10,00,00,000 x (7.25/100) x (90/365) = 17,87,671
Bank B would pay = 10,00,00,000 x (7.45/100) x (90/365) = 18,36,986
Net Pay from Fund A to Bank B = Rs. 49,315
After 3 months had the MIBOR compounded daily turned out to be 7.45% then Bank B would have to pay Rs.49,315.
Fund A thus benefits if interest rates rise. Bank B benefits if interest rates fall
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