Faced with the looming threat of rising interest rates, mutual funds and banks have stocked up on variable rate bonds (FRBs). They are bonds whose interest payments (called coupons in technical terms) are linked to the overall rates of the economy. Therefore, they offer protection to investors in a rising interest rate environment. Government-issued FRB holdings fell from almost zero in September 2019 to ??51,000 crore in September 2021, according to data from a major financial services firm. However, some senior industry executives have independently raised concerns about the debt frenzy. FRBs are not held only in floating rate funds but in various other short term categories such as short term or short term funds.
The risk here is not of default, but of liquidity and bad pricing. According to the aforementioned rulers, trading in these bonds represents a few hundred crore overnight. “FRBs can sometimes become illiquid and be subject to significant price movements. In addition, given that the exceptional size of FRBs has only recently increased, it is difficult to determine how they will behave in the event of a change in monetary policy, ”said Sandeep Yadav, Head of Fixed Income, DSP Investment. Managers. “Major risk with FRBs. is liquidity, which can sometimes lead to wrong prices. This is especially true when most of the participants end up being on one side of the market. “
When investors buy debt mutual funds, they usually look at a measure called “modified duration.” This metric tells you how the value of a fund’s portfolio changes in response to a percentage increase in interest rates. For example, if the modified duration is 3 and the interest rates increase by 1%, the NAV (net asset value) of the fund will decrease by 3%. However, FRBs are an anomaly. Their modified duration is low because their interest is tied to a variable benchmark, giving investors what can be a false sense of comfort. However, their actual maturity, especially for government bonds, is much higher around 10-12 years. “The price of a floating rate bond is linked to two things. The first is the external benchmark such as the repo rate or the yield on 3-month treasury bills. Second, the spread on that yield. Now that spread is subject to changes in market value that are tied to the actual maturity of the bond which could be 10 years from now, ”said a senior industry executive who declined to be named.
Currently, approximately ??4.3 trillion public FRBs are in circulation, the bulk of which is held by banks. According to the head of fixed income at a large fund company, the government also finds FRB a convenient way to manage its debt. Instead of issuing short-term securities that mature frequently, forcing the government to borrow again, an FRB has a long-term maturity. The government only has to pay a variable coupon. Banks buy these bonds because they have long-term assets such as home loans, which also have variable interest rates.
In addition to ??51,000 crore exposure to government FRBs, the MF industry also has a ??24,000 crore exposure to corporate FRBs.
Fund houses are very divided on their perception of FRBs. “In a scenario where the interest rate cycle has bottomed out and the central bank seeks to raise rates, investors become cautious by investing in fixed rate bonds and FRBs become a natural choice for investors. . The RBI has yet to start raising interest rates and investor preference throughout the rate hike cycle remains positive for FRBs. The existing spreads of the FRBs issued by the GoI for the 2031-34 maturities currently in the primary auctions / switch are between 80 and 110 bps, which is attractive from a historical point of view and compared to other spreads of risk in the market, ”said Manish Banthia, senior fund manager. at ICICI Prudential Asset Management Co.
“The auction coverage ratio in auctions, which reflects investor interest, has been very high. The last auction on November 18 had a bid coverage ratio of over 3 times. Demand from market players has been so high that GoI issued FRBs in monthly auctions. The past two months have seen demand for around ??40,000 crore in FRB from investors in switching auctions. With such demand and participation from all kinds of investors, the issue of bad pricing and liquidity is misplaced. The holding of mutual funds in FRB issued by the Indian government is only around 10% and banks remain the main holder of FRBs issued by the Indian government, ”he added.
“Implicit market spreads (deviation from the benchmark) are largely a function of market expectations for rates as well as short-term demand and supply. In the short term, due to other market actions, spreads may change. For example, in October, the RBI announced a larger change in ??36,000 crore entirely in FRB (passage of shorter fixed-rate government securities in FRB) unlike the usual passage of ??6,000 crores in FRB. This caused FRB price volatility, pushing implicit market spreads from 100 basis points to 105 basis points from now on. At the same time, the base index, i.e. 6 month bills, fell from odd 3.40% to around 3.81%, which recently led to an increase in accumulation. “said Rajeev Radhakrishnan, Head of Fixed Income at SBI Mutual Fund.
Investors should be aware of the large differences between the modified duration and the average maturity of their debt UCITS, especially in categories such as short duration or short duration. “Investors should be aware that FRBs are significantly more volatile than securities of similar duration. In general, the longer the gap between maturity and duration, the higher the volatility, ”said Yadav of DSP Mutual Fund.
If such a mismatch exists, speak to a financial advisor to understand why and to what extent floating rate bonds are present in the portfolio.
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