A floating rate fund (quarterly resets, spread duration 2.5, rate duration 0.3) and a short duration fund (duration 2.4) both yield 7.4%. If rates rise 100 basis points and credit spreads widen 50, what does each lose, and which risk did the floater investor keep?

The floater loses about 1.55 points on the day, the short duration fund about 3.60, and the floater's investor kept the credit spread risk in full. The floater's loss is 0.30 from rates and 1.25 from spreads; the short duration fund's is 2.40 and 1.20. Over a year the floater recovers its rate loss at the first reset and its coupon steps up, ending near 6.9% if spreads stay wide, while the short duration fund ends near 5.3%. A floater removes rate risk; it does not remove the issuer.

A bond's yield has two parts: the benchmark rate and the spread the market charges for the issuer's credit. A floating rate bond resets the first part every quarter and fixes the second for its whole life. A shop tenant on a rent that tracks an index every quarter is protected from inflation in rents, but if the shop's own street goes downhill, the lease still runs for three years. Rate durationPrice sensitivity to a change in benchmark interest rates. For a floater it is roughly the time to the next coupon reset, because the coupon catches up with the market then. measures the first exposure; spread durationPrice sensitivity to a change in the credit spread over the benchmark. For a floater it is close to the remaining life of the bond, because the spread does not reset. measures the second, and a floater resets only the first. That is why the two numbers are 0.3 and 2.5 for the same fund.

Multiply each duration by its own shock. Floater: rates, 0.3 x 1.00 = 0.30 points; spreads, 2.5 x 0.50 = 1.25 points; total 1.55 points, of which 81% is the spread. Short duration: rates, 2.4 x 1.00 = 2.40; spreads, 2.4 x 0.50 = 1.20; total 3.60 points. On the spread leg the floater actually loses slightly more, because its bonds are a little longer. The distributor's claim is true of exactly one of the two shocks.

Run the shocks one at a time. A pure rate rise of 100 basis points costs the floater 0.30 points and the short duration fund 2.40; a pure spread widening of 50 costs them 1.25 and 1.20, almost the same. The floater's investor swapped rate risk for nothing and kept credit risk whole. That matters because the two shocks tend to arrive together: tightening cycles squeeze weaker borrowers, and spreads widen most when rates are rising fastest. The investor who bought the floater to sleep through a hiking cycle still owns the same issuers as the short duration fund, and will feel the same credit scare.

The day-one loss is not the year. The floater's 0.30 rate loss disappears at the first reset, when its coupons step up by the full 100 basis points for the remaining three quarters; if spreads stay wide, it ends the year near 6.9%: 7.4 of carry, less 1.25 of spread loss, plus about 0.75 of higher coupon. The short duration fund keeps its lower prices but its bonds pull back towards par as they shorten, recovering roughly a year's worth of the loss over the year, so it ends near 5.3%. These are approximations that ignore the roll-down and reinvestment, but the ranking is robust: in a year of rising rates the floater wins, and in a year of widening spreads both lose the same.

Close with the limit and the view. In India many floating rate funds hold fixed-coupon bonds and swap them to floating with interest rate swaps, which adds basis risk between the swap benchmark and the bonds, and the category rule on minimum floating-rate holdings shapes how pure the fund can be; confirm the current figure. The view for the distributor: sell the floater as a fund that is protected from rate rises, never as one without credit risk, and tell the investor that its credit quality, not its reset frequency, decides what it does in a credit scare.