With the impending threat of rising interest rates, mutual funds and banks have loaded up on floating rate bonds (FRBs). They are bonds whose interest payments (called coupons in technical terms) are linked to overall rates in the economy. Hence they offer protection to investors in a rising interest rate environment. Holdings of government-issued FRBs have gone from near zero in September 2019 to ₹51,000 crore in September 2021, data from a large financial services firm showed. However, some senior executives in the industry have independently raised concerns on the debt binge. FRBs are not held solely in floating rate funds but in various other short-term categories such as low duration or short duration funds.
The risk here is not of default, but of liquidity and mispricing. According to the aforementioned executives, the trading in such bonds is a few hundred crores on a day-to-day basis. “FRBs can, at times, turn illiquid and be prone to significant movements in prices. Moreover, since the outstanding size of FRBs has increased only in recent times, it is difficult to ascertain how they will behave under a change in monetary policy,” said Sandeep Yadav, head – fixed income, DSP Investment Managers. “Major risk with FRBs is liquidity, which can at times lead to mispricing. This is especially true when most participants end up being on one side of the market.”
When investors buy debt mutual funds, they generally look at a measure called ‘modified duration’. This metric tells you the change in the value of a fund’s portfolio in response to a percentage rise in interest rates. For example, if the modified duration is 3 and interest rates rise by 1%, the NAV (net asset value) of the fund will fall by 3%. However, FRBs are an anomaly. Their modified duration is low because their interest is linked to a variable benchmark, giving investors what may be a false sense of comfort. However, their actual maturity, especially for government bonds, is much higher at around 10-12 years. “The price of a floating rate bond is linked to two things. First is the external benchmark like the repo rate or 3 month treasury bill yield. Second is the spread over that yield. Now this spread suffers 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.
Currently, around ₹4.3 trillion of government FRBs are outstanding, with the bulk being held by banks. According to the head of fixed income at a large fund house, the government also finds FRB a convenient way to manage its debt. Instead of issuing short-term paper that frequently matures, forcing the government to borrow again, an FRB has a long-term maturity. The government only needs to pay a variable coupon. Banks buy these bonds since they have long dated assets such as home loans, which also have variable interest rates.
In addition to the ₹51,000 crore exposure to government FRBs, the MF industry also has a ₹24,000 crore exposure to corporate FRBs.
Fund houses are sharply divided on their perception of FRBs. “In a scenario where interest rates cycle has bottomed out and the central bank is looking to move the rates higher, investors become cautious of investing in fixed rate bonds and FRBs become a natural choice for investors. RBI is yet to start raising interest rates and investor preference through the rising rate cycle remains positive for FRBs. The existing spreads of FRBs issued by GoI in 2031-34 maturities currently in primary auctions / switch are between 80-110 bps 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 Co.
“The bid cover ratio in auctions which depicts investors’ interest has been very strong. The last auction held on 18 November had a bid cover ratio of more than 3 times. The demand from market participants has been so high that GoI has been issuing FRBs in the monthly auctions. The last two months saw demand of around ₹40,000 crore in FRBs from the investors in the switch auctions. With such a large amount of demand and participation from all kinds of investors, the question of mispricing and liquidity is misplaced. Mutual funds holding of FRBs issued by GoI is just about 10% and banks remain the largest holder of FRBs issued by Government of India,” he added.
“The market implied spreads (spread over benchmark) are largely a function of market expectations on rates as well as near term demand and supply. In the near term on account of other market actions, the spreads can change. For example, in October, the RBI announced a larger switch of ₹36,000 crore entirely in FRB (switching shorter fixed rate government securities to FRB) unlike the usual switch of ₹6,000 crore in FRB. This led to price volatility in FRBs’ leading to market implied spreads moving from 100 basis points to 105 basis points as of now. At the same time, the based index , that is, 6 month bills have moved up from 3.40% odd to about 3.81% recently leading to higher accrual,” said Rajeev Radhakrishnan, head of fixed income at SBI Mutual Fund.
Investors should watch out for big mismatches between the modified duration and the average maturity of their debt mutual funds particularly in categories like low duration or short duration. “Investors should be cognizant that FRBs are significantly more volatile than the similar duration papers. Usually longer the gap between maturity and duration, the more the volatility,” said Yadav of DSP Mutual Fund.
If such a mismatch exists, speak to a financial adviser to understand why and to what extent floating rate bonds are present in the portfolio.
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