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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.

 
 

 

 

 

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.

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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%.

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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

V Floating rate debentures and bonds

 V Short tenor fixed rate instruments
V ong tenor fixed rate instrument swapped to floating rate (Interest Rate Swaps)

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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.

  



Most floating rate funds also invest in something referred to as 'ong 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.


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.
Introduction A bond is a long term debt obligation. It is sold by the borrower who is called the
"issuer" in order to borrow money for the medium and long term. Typically a bond will have a
maturity of between 2 and 20 years. The issuer can be a bank, company or government
institution. A bond normally has a known maturity or redemption date and during its life pays the
investor interest. The interest payments are called "coupons". Bond investors rank prior to equity
holders in liquidation but are subordinate to secured lenders. From an issuer's perspective the
coupons are usually tax deductible (unlike dividend payments on equity). Bond markets provide
investors with variety. One of the most frequently issued bonds is called a floating rate note.