A normal income fund invests in high quality debt papers of companies and the government. Most of these debt papers carry a fixed coupon rate for paying interest.
So, the funds earn a fixed predetermined interest over the tenure of the bonds. So, if fund `A' had say, invested Rs 1 lakh in 8% bonds, it would earn Rs 8000 every year as interest till the end of the tenure.
Such fixed-interest bearing papers show greater vacillations in their prices than a floating-rate bearing paper, when interest rates move up or down. Why is that so? This is because in the case of the former, there are no provisions for adjusting future interest rate payments.
This would mean if the interest rate for a similar rated corporate paper rises to 9% per annum, the company which issued debt papers still continues paying interest at 8% per annum.
To reflect current trends, the market price of the bond falls to effectively yield 9% per annum for new debt investors. Floating-rate income funds, by contrast, invest primarily in bonds whose coupon rates change over the tenure with the market rate.
As a result, their coupon rates change during the tenure, in sync with market rates. This, to a certain extent, reduces the interest-rate risk of the debt portfolio.
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