The “long” and “short” of debt funds

Right now, as interest rates threaten to rise, investors are wondering which funds are appropriate and which funds should they come out. Before we discuss the orientation part, let’s take a look at some relevant facts to make it easier to understand.

The 16 categories of debt funds are defined by SEBI in terms of outlines, that is, what a fund in this category is supposed to do. Therefore, when you make the decision to invest in a fund, you can look at the parameters of this category and get a fair idea.

Debt funds derive their returns from two paths: accrual accounting and mark-to-market (TMM). Accumulation is the coupon or interest that accumulates on bonds and other portfolio instruments. Mark-to-market is the valuation carried out each day, for the calculation of the net asset value, according to the prevailing market prices for the instruments in the portfolio. The yield (interest rate) and bond prices move in the opposite direction; if yield levels increase, prices fall and the MTM impact is unfavorable. If interest rates in the market fall, the impact is positive.

When yields or interest rates in the market rise, the immediate impact is unfavorable. However, over time, the level of accumulation increases. New money entering the fund is invested at higher yields and as securities mature, reinvestments occur at higher yields.

The longer your investment horizon, the better. You have so much more accumulation to absorb any MTM loss. In addition, over a long period of time, the market moves in cycles, i.e. interest rates rise and fall and then stabilize.

For example, suppose a debt fund has a portfolio of 100 and on a bad day the negative impact of the MTM was ₹ 1.5. The fund’s accumulation level is, say, 6%. If you had invested in the fund the day before, you would see minus 1.5% on your statement. If you stay invested for three months your returns would be zero as the fund had accumulated ₹ 6/4 = ₹ 1.5. Over a one-year holding period, your return is 6 minus 1.5, or 4.5%.

If you have a horizon of, say, 10 years, the accumulation will be all the greater and the impact of the MTM will be negligible. It should be noted that the MTM impact can also be favorable when performance levels drop.

The maturity of a debt fund portfolio is the weighted average maturity of all instruments in the portfolio. The longer the maturity of the portfolio, the greater the variability of market movements. In other words, debt funds with a longer maturity are more volatile and the MTM impact – both favorable and unfavorable – is higher. In this sense, short-maturity funds are defensive.

With that background, let’s come now to the tips on what to do:

Since yields / interest rates are expected to increase gradually over the next year, it is advisable to switch from long-dated debt funds to short-dated ones. That said, if you have a long enough investment horizon, you can stay invested even in long-term funds. As mentioned earlier, accumulation over a longer period and multiple market cycles will equalize intermediate volatility.

If you can’t stomach the volatility, you can gradually move from long-dated funds to short-dated ones. On what is an adequate investment horizon, there is no strict definition; Basically, if your horizon is more or less equal to the maturity of the portfolio, you are safe. By way of example, for a fund with a portfolio maturity of three years, a horizon of three years is adequate and for a fund with a maturity of 10 years, a horizon of 10 years is desirable.

Also check the quality of the wallet. If your horizon is say three years or more, to benefit from tax efficiency, there are funds in the categories bank and PSU, corporate bonds, short duration, etc. The factsheet of the fund in which you intend to invest is available on the AMC website. All the details on the maturity of the portfolio, the composition of the portfolio, etc. are available on the fund file.

From a credit risk perspective, government security funds are the best. However, these funds have a relatively longer portfolio maturity and are more volatile. Therefore, a long investment horizon is imperative for G-Sec funds.

For the deployment of new money, which does not have the advantage of accumulation like in the case of funds in which you had already invested, think about the time horizon you have and whether you like the initial volatility that can occur, in case the yields increase and MTM is unfavorable. For existing investments, if they are long-term funds and you want to stay in place for three years for tax efficiency reasons and are approaching three years, you can stay in place.

The rise in yields should be gradual and calibrated. If you have completed three years and your corpus is already fiscally advantageous, it is a question of remaining horizon. If the remaining investment period is six months or one year, you can move to a shorter maturity. If your remaining period is a few more years, you can stay put.

There is a common belief that in a scenario of rising interest rates, floating rate funds are recommended as they would benefit from rising interest rates. However, this is not an individual correspondence. The explanation is technical; to put it simply, real floating rate bonds, where the coupon rate is calibrated to say the MIBOR (which moves with the rates set by the RBI) are rare. These fund portfolios are built like “synthetic floats”.

Conclusion

If you are working with an advisor or distributor, you can get advice. If you are a handyman, you can do a review of your debt fund portfolio according to the parameters described above. Note that the expected increase in yields over the next year or so would be gradual and you have time to make any changes.

(The writer is a corporate trainer (debt markets) and author)

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