Navigate interest rate hikes with investment in these debt mutual funds
Investment in these funds should be in line with investors’ risk appetite and goals. Investors also need to stay abreast with the latest developments and wait for the next policy meet to get cues for the road ahead and plan accordingly.
The Reserve Bank of India (RBI) recent interest rate hike surprised everyone. The timing, quantum and unexpected rate increase calls for the investors of the debt oriented mutual funds to alter their investment strategy. Change in the investment strategy will aid to mitigate the downside risk, attain optimum returns and navigate through further inevitable interest rate hikes by the central bank. In this article we list down the debt fund variants which will benefit in the rising interest rate scenario. Investment in these funds should be in line with investors’ risk appetite and goals. Investors also need to stay abreast with the latest developments and wait for the next policy meet to get cues for the road ahead and plan accordingly.
Allocate money in liquid funds and ultra-short-term funds
In the backdrop of the rising interest rate, investors can allocate their money into liquid funds, ultra-short-term funds or money market funds. Liquid funds are least risky among debt fund variants and ideal for very short-term goals like building of emergency funds. These funds invest in debt and money market securities with maturity of up to 91 days. Investors can also consider ultra-short term funds investing in debt and money market instruments with macaulay duration of the portfolio between 3 months - 6 months and money market funds investment in money market instruments having maturity up to one year. These categories are best bet to meet the short term capital requirement and relatively less risky compared to other debt funds.
Go for short duration funds and avoid long duration funds
Short duration funds invest in the debt and money market instruments with Macaulay duration of the portfolio between 1 year - 3 years. These funds can be good investment avenue for the investment horizon of 1 to 3 years. Note these funds fall in the middle in other words they are riskier than liquid, ultra short-term funds but less risky than the medium and long duration funds. During the rising interest rate scenario, the long term and gilt funds tend to suffer as bond yields and bond prices have inverse relation. These funds need prices to rise to make the profits but with rise in the interest rates they suffer mark to market losses and hence it makes sense to invest in short duration funds as these park money in papers with higher coupon.
Floater funds can help to hedge against the interest rate risk
Floater funds invest 65% of their portfolio in floating rate instruments (including fixed rate instruments converted to floating rate exposures using swaps/ derivatives). These funds tend to perform well when the interest rate rise in the economy since the underlying securities of the fund readjust their yields on par with prevailing interest rates. Most of the schemes tend to invest in short duration securities making them less sensitive to interest rate changes. Investors should make a note of the underlying risk factors such as re-investment risk and credit risk of the portfolio prior to investing.
Options for medium to long term horizon
In addition, investors having higher risk tolerance ability and medium to long term investment horizon can consider investing in credit risk funds with the improvement in the economic cycle, banking and PSU funds investing in debt instruments of banks, PSUs and gradually invest in target maturity funds. Several fund houses have recently launched target maturity funds – a passively managed debt funds (index or ETFs). These funds mirror an index of government securities, PSU bonds, state development loans or combination of all and accordingly create of portfolio of the underlying securities. They are good avenue for investors aiming to invest for the specified period and some predictability of returns. Investment for more than three years qualifies for long term capital gains taxes with indexation benefit.
With the gradual increase in the interest rate, investors of the debt mutual funds need to tweak their portfolio. We have list down some of the categories above but note debt mutual funds are market linked avenues and does not offer guaranteed returns unlike traditional avenues. Evaluation of the risk factors with each of these categories, due diligence of the fund and investing in line with risk tolerance ability is essential.