Floater Rate Fund is an open-ended debt scheme predominantly investing in floating rate instruments (including fixed rate instruments converted to floating rate exposures using swaps/ derivatives). These schemes will invest at least 65% of its net assets in floating rate instruments.
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Floating Rate bonds carry a coupon rate, which is linked with an external benchmark, e.g., the repo rate, G-Sec yield, MIBOR (Mumbai Inter-Bank Offer Rate), etc. As such, the coupon rate for floating rate bonds will be expressed as the benchmark rate plus risk spread as applicable to the issuer company.
The examples of such bonds may be 10-year G-sec yield plus 175 bps, MIBOR + 10 bps, etc. While there might be daily movements in the benchmark interest rates, the applicable reference rate is fixed on a periodical basis, say half-yearly basis or annual basis, matching with the interest payment frequency.
As on 31st May 2020, floater funds have around 2.8% share across the overall AUM (Assets Under Management) of open-ended debt schemes with AUM of Rs. 0.32 lakh crores
Source: Association of Mutual Funds in India - AMFI
Source of Returns
Floater funds may generate returns for the investors in two modes:
· Accrual Income
While debt securities pay interest on a periodical basis, the investor becomes entitled to the interest income daily. This is referred to as the accrual concept. Other things remaining the same, the daily accrual over one year will be equal to the yield.
Since the coupon rate of floating-rate bonds fluctuates across the tenor of the security, such accrual income continues to change over time. However, to maintain the attractiveness of floating rate securities, the spreads over the external benchmarks may be kept relatively higher to mitigate the risk of changes in interest rates.
· Valuation Changes
The valuation of debt securities may change due to the changes in the credit rating of the issuer entity since the credit spreads tend to move in the opposite direction as that of the credit rating. As such, floating-rate bonds may appreciate, if the credit quality of the issuer entity improves.
Pros and Cons for Floating Rate Securities
A significant benefit of floating-rate securities is that the valuation of such bonds is immune to interest rate changes, as the coupon automatically adjusts with the market yields on specified intervals. Since the floater funds may help the investors mitigate the interest rate risk on the portfolio valuation, the changes in the coupon in line with the movement in the benchmark rates do not tend to impact the portfolio valuation over time. Thus, the valuation of such bonds tends to stay relatively stable.
On the other hand, such debt securities may not be generally preferred by retail investors, due to uncertainty in the future interest income.
Tax Incidence of Floater Funds
Since at least 65% portfolio of such funds must be invested in floating rate debt securities, such funds are categorised as non-equity oriented mutual funds. As per the provisions of the Income Tax Act, 1961, any income from mutual funds is taxed at the time of receipt of dividends or redemption of mutual fund units.
Finance Act 2020 removed the applicability of Dividend Distribution Tax (DDT) and, instead, made such dividend income taxable for the investor at the regular tax rates as applicable to the investor. Further, mutual funds are also liable to deduct TDS at the rate of 7.50% (reduced rate by the Govt. because of Covid-19 measures till 31st March 2021) on such dividend income if the total dividend paid by the mutual fund house to an investor exceeds Rs 5,000 in a year.
On the other hand, the appreciation in the NAV (Net Asset Value) of mutual fund units is taxable as ‘Income from Capital Gains’. Such gains funds are categorised as Short-Term Capital Gains (STCG) and Long-Term Capital Gains (LTCG) based on the holding period of mutual fund units.
If the investor has held the units for less than 36 months, the returns are taxed as STCG at the regular tax rates applicable to the investor. However, in case the holding period has been 36 months or more, the gains are classified as LTCG and taxed at 20% (plus applicable Cess and surcharge) with indexation benefit. The indexation benefit effectively lowers the tax incidence for the investors from the fund returns.
Note: The tax provisions, as mentioned in the article, are for illustrative purposes only, and are updated as per the Union Budget 2020 passed by the Parliament and the Covid-19 related measures announced by the Govt. The tax rates for capital gains will be as per the tax laws applicable on the date of redemption/ sale and not on the date of investment.