Investors investing in debt mutual funds primarily face two major risks: interest rate risk and credit risk. Credit Risk is the risk that the bond issuer will default on its obligation to pay principal/interest in a timely manner.
Interest rate risk refers to the risk that occurs from changes in the prevailing interest rates in the economy. An upward movement in the rates makes existing debt instruments less attractive.
For example, let's assume that you hold a bond which pays a coupon of 7%. Subsequently, interest rates rose, and now newly issued bonds of similar tenure offer 7.5%. This will lead to a drop in the price of the original bond in the secondary markets, causing it to offer an effective yield of 7.5%. In the case of a debt mutual fund, a price drop leads to a corresponding drop in the fund's Net Asset Value (NAV) and vice versa.
The magnitude of the price drop depends on the fund's duration. Duration is a measure of interest rate sensitivity. The higher the duration, the greater the impact of a rate movement on the NAV.
Therefore, the returns from a debt mutual fund are contingent on interest rates and fund duration. You can make attractive returns from debt funds if you can effectively position your portfolio to take advantage of the interest rate cycle.
Since April 2022, the RBI has raised the repo rate by 250 bps from 4% to 6.5%. We are nearing the end of the rate-hike cycle with a possibility of another 25 bps hike. Thereafter, we can expect this trend to reverse by the end of the year.
This is an opportune time to lock in high yields by investing in Target Maturity Funds as part of your 'Core' portfolio and simultaneously invest in Long Duration Funds to benefit from the rate cycle. Let's understand how.
Target Maturity Funds (TMFs) are passive debt funds with a pre-defined maturity date that invest majorly in Government/State bonds. You can get the returns indicated at the time of investment if you stay invested till the maturity of the fund. Like fixed deposits, you have both a high visibility of returns and a defined maturity.
Today, TMFs offer a yield-to-maturity between 7.5-7.75%, depending on the tenure. With another rate hike on the horizon, you should stagger your investments in TMFs over the next 3-6 months and lock in the high yields. If you stay invested in these TMFs till their defined maturity, you will be able to get the indicative returns minus the expense ratio.
On the flip side, while rising interest rates make defined-maturity passive instruments attractive – the near-end of the rate-hike cycle also makes it an appealing time to increase the duration of the portfolio and invest in Long Duration Funds (LDFs). Since LDFs are highly sensitive to interest rate movements due to their higher duration, it stands to benefit the most when rates trend downward.
Example: Let’s say that an LDF has a duration of 6 years and a yield-to-maturity of 8%. If rates drop by 1%, then the fund will gain +6% over and above the YTM of the fund translating to a total gain of +14%.
However, it can also work the other way around, and thus it is important to stay vigilant when investing in LDFs due to their highly volatile nature. Depending on the underlying macroeconomic environment, take a 1-2 year view when investing in these as part of your 'Satellite' debt portfolio.
Debt funds have started to look like an attractive proposition after the meagre returns offered by them over the past two years. But equally, be aware of the risks associated with it when investing in it.
Varun Fatehpuria is the Founder & CEO ofDaulat.