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Edelweiss Mutual Fund said that FRBs are generally preferred by fund managers during periods of the upward-moving interest rate cycle.

There has been a sudden spurt in investor interest in floating rate bonds (FRB) in CY21. Floating Rate Funds have received a net inflow of around Rs 21,000 crore in this calendar year so far, the second-highest net inflow after Money Market Funds, signifying their interest. The Government of India (GOI) has also been quite active in supplying FRBs through scheduled auctions on a periodic basis. There are four outstanding IGB FRBs with around Rs 3.8 trillion of outstanding face value with GOI 2033 FRB being auctioned on fortnightly basis. Recently, Power Finance Corporation Limited, an AAA-rated CPSE, issued a 3-year FRB linked to 3-month T-Bills, which drew strong investor interest. Many more FRB issuances are in the pipeline.

According to Edelweiss Mutual Fund, FRBs are popular among investors during periods of rising interest rates or upward-trending bond yields. Investors view FRBs as a defensive play in their fixed income portfolio during such times. FRBs are designed to shield investors from vagaries of price volatility of fixed-rate bonds during an uptrend in bond yields.

FRBs encompasses issues whose coupons are tied to a benchmark or an index. In general, a pure FRB has the following components:

Index: They are liquid and widely followed benchmarks in the bond market such as MIBOR, 3M or 6M T-Bills, Reuter’s INBMK rates. The underlying index remains the same through the life of the FRB.

Selection of a suitable index and its look-back period (such as closing levels of average number of days before the next reset date) are important determinants for the pay-off to investors.

Reset frequency: The index is generally reset on a periodic basis – daily (in case of MIBOR) or quarterly or six-monthly. Most FRBs reset on a quarterly basis in India. FRBs with quicker reset frequency is generally preferred during a potential upward trend in the underlying index while FRBs with longer reset frequencies are preferred when the underlying Index is expected to trend lower.

Quoted Margin (QM): This is the spread the issuer is willing to offer over and above the index level on an annualised basis. In a pure FRB, QM remains constant during FRB’s tenor. QM can be viewed as either a term premium or credit spread the issuer offers to investors. QM is a function of the issuer’s creditworthiness as well as tenor of the FRB.

Maturity Date: Each FRB has a defined maturity date on which FRB investors receive the maturity value plus last tranche of coupon payment.

Payment Frequency: Frequency at which coupons are going to be paid. This is generally the same as reset frequency.

In developed markets, different variants of FRBs have been quite popular among investors. This includes FRBs collateralised by asset-backed securities, mortgage-backed securities as well as FRBs with Cap & Floor structures, among many other structures.

Investment strategies involving FRBs

Edelweiss Mutual Fund said that FRBs are generally preferred by fund managers during periods of the upward-moving interest rate cycle. Secular increase in the underlying index (MIBOR, 3M/6M T-Bills, INBMK, etc.) on periodic reset dates helps investors in capturing higher coupons. This helps in generating higher returns for investors.

FRBs are also generally seen as better yielding alternatives to short-term CP/CDs with maturities identical to the next reset date of the Underlying Index. This is because credit spread in form of Quoted Margin (QM) is generally higher than credit spreads of short-term CP/CDs.

During periods of stable interest rates, FRBs are generally used to optimise Barbell portfolio strategies as an alternative to short-term allocation. Short maturity inverse floaters, whose pay-off is inversely linked to the movement in the underlying index, are quite effective as a substitute of short-term assets during periods of rapid decline in the underlying index.

“Indian debt fund managers have been quite versatile in their use of FRBs since 2005. MIBOR-linked FRBs with daily put/call options and their variants gained popularity as substitute of cash deployment. Steeper yield curves introduced INBMK-based FRBs to optimise portfolio returns. In 2012, the GOI introduced Indian version of TIPS linked to India’s Wholesale Price Index (WPI), which was well received by investors,” Edelweiss said.

Key issues

As they say, there is no free lunch in financial markets. Investors of FRBs need to understand the following key issues:

Tactical Investment: FRBs are generally useful as tactical play during a short period of time when the underlying Index is likely to trend higher. Therefore, it is important to time the entry and exit of FRBs to optimise returns. Long-term / Hold-To-Maturity investors are generally better off investing in a fixed rate bond of similar maturity than an FRB.

Liquidity in the secondary market: Since FRBs gain popularity during an upward trend in index levels, their secondary market liquidity is quite important. Liquidity generally improves when the index is ready to trend higher or on the uptrend. Liquidity generally dries down when index levels are at peak or closer to peak.

Price sensitivity: Long-term FRBs will exhibit higher price volatility than short-term FRBs.

Structures: FRBs come in different types of structures. FRBs with cap and floors, step-up structures, inverse structures, etc. tend to behave differently. Therefore, it is important to pay attention to their structures and the factors driving their valuations.

Issuer preference: It is generally cheaper for any issuer to issue an FRB as it tends to reduce their aggregate borrowing costs. As a result, any indication of higher demand of FRBs is generally met with increased primary supply. This tends to put upward pressure on discount margin (DM), thus reducing valuations of other FRBs in theory and affecting secondary market liquidity as well.