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How to tackle rising interest rates
Personalfn.com | May 12, 2008 16:32 IST
As if any proof was needed, the spate of Cash Reserve Ratio hikes clearly underlines the Reserve Bank of India's [Get Quote] intention to clamp down on inflation before the situation deteriorates any further.
For risk-averse investors that's bad news. It is widely acknowledged that rising interest rates can knock the wind out of conventional (read fixed rate) debt/debt fund investments. But what investors would really like to know is, if there is a way to tackle this situation.
Floating rate funds is the answer
The good news is that there are ways to negotiate rising interest rates and one way to achieve that is by investing in floating rate bonds/funds. As the name implies, floating rate investments vary from conventional (fixed rate) investments mainly in terms of the coupon rate i.e. the coupon is revised at regular intervals (i.e. floating) in response to changes in the benchmark rate. Consequently, if there is a rise in the interest rate, the coupon rate usually reflects this change, thereby securing the interests of investors during a rising rate scenario.
Floating rate funds invest predominantly in floating rate securities and imbibe similar characteristics. So when interest rates firm up, investors in floating rate funds witness lower volatility and are better equipped to cope with the situation.
To highlight this fact, we ran a query for the biggest year-to-date losers in the conventional long-term debt fund segment (these are the funds that invest predominantly in fixed rate securities). The reason for choosing the YTD parameter is obvious; this is the period marked by turmoil in debt markets and the CRR rate hikes.
(Year to date return indicates the performance of the mutual fund since the beginning of the calendar year upto May 7, 2008. The growth option has been considered for all mutual funds. This is a listing of all YTD losers in the long-term debt fund category.)
As is evident from the table, conventional long-term debt funds have struggled a bit to remain in positive territory. As many as six debt funds posted negative returns on YTD.
Floating rate funds come out tops
And how did long-term floating rate funds fare over this time frame? Quite well considering that not a single long-term floating rate fund slipped into negative terrain.
Investors looking for capital preservation during times of rising interest rates cannot afford to ignore floating rate investments. However, they must note that while floating rate funds do well in a rising interest rate scenario, when the scenario turns (i.e. interest rates fall), floating rate funds underperform their fixed rate counterparts.
So it's advisable to have a debt fund portfolio with adequate allocation for various categories so that investors are well placed to benefit from various phases of the interest rate cycle.Your family's future depends on this. Read now
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