scorecardresearchWorried about rate hikes? Look at short term debt funds to ride out volatility

Worried about rate hikes? Look at short term debt funds to ride out volatility

Updated: 13 Jul 2022, 03:07 PM IST
TL;DR.
Experts suggest that modified duration is one of key metrics to determine the choice of debt funds. The longer the duration, the more volatile the debt funds.
The fund managers also argue that the bond market has already discounted a larger part of the rate hikes 

The fund managers also argue that the bond market has already discounted a larger part of the rate hikes 

Amid high inflation that precipitated the Reserve Bank of India (RBI) to raise repo rates by a total of 90 basis points in past few months, bond yields have followed suit.

This was followed by decline in bond prices since yields and bond prices move in opposite directions. As yields rise, prices tend to decline and when yields fall, bond prices rise.

Fund managers expect the RBI to continue raising repo rates. In the wake of this rising interest rate cycle, investors are keen to know the debt funds they should select and the key criteria to do so.

Financial experts say that one of the key ratios that can help the investors decide is modified duration which determines the sensitivity of debt funds to interest rate changes.

“There is inflationary environment as of now, and RBI has already raised repo rates by 90 basis points and is likely to raise them further. Given that bond prices and interest rates are inversely related, bond prices have fallen, and further increase in interest rates would cause bond prices to fall further. This has led to many debt funds giving negative returns. But investors must understand that not all debt funds react in the same manner to interest rate changes,” said Ravi Saraogi, cofounder, Samasthiti Advisors.

“They should look at the modified duration which shows how sensitive the fund is to the changes in interest rates. If you want to play safe, you should choose the funds that are low on modified duration such as liquid funds, ultra-short term or short-term funds. You should ensure that your debt mutual funds have less than one year of modified duration,” he added.

What is modified duration?

The modified duration calculates the price sensitivity of a bond when there is a change in the yield to maturity. In other words, it determines the changes in a bond's duration and price for each percentage change in the yield to maturity

As shown in the charts below, in case of ultra-short-term funds where modified duration is in the range of about 150 days, the returns have been stable.

For Gilt Funds, on the other hand, where the modified duration is very high — the funds have delivered negative return in the past few months.

So, investors can choose a debt mutual fund with low modified duration, preferably below 365 days. In case the investor has a low-risk appetite, they should go for debt mutual funds with an even lower modified duration i.e., below 150 days.

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Returns given by ultra short funds in past six months.

(Source: Samasthiti Advisors, data as on June 15, 2022)

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Returns given by gilt funds in the past six months

Long duration funds

Investors are advised to stay away from longer-duration funds as of now. But once inflation has softened and the interest-rate cycle turns, that would be the time when investors can invest into longer duration funds.

Fund managers assert say that after the RBI’s rate-hike cycle ends, the adverse mark-to-market impact will come to an end. It’s after this, debt-fund returns will improve.

The fund managers also argue that the bond market has already discounted a larger part of the rate hikes. It is likely to be less sensitive hereafter to further hikes by the central bank.

There is another view according to which, investors should invest into fixed maturity plans and hold them till maturity. Investors who want higher yields should buy and hold target maturity funds.

“When the interest rates are on a rise, one way is to go for short duration and liquid funds. And the other way is to explore fixed maturity products which investors can buy and stay invested into until their maturity. For example, Bharat bond ETF offers an assured returns of 7-7.75 percent if you are willing to hold it until maturity. Now whether these returns are good or not depends on the investor’s expectations and financial goals,” says Deepesh Raghaw, Co-founder of PersonalFinancePlan.

 

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First Published: 13 Jul 2022, 10:29 AM IST