Where can debt mutual fund investors invest in a rising interest rate scenario?

 

The Reserve Bank of India, in its bi-monthly monetary policy held in June, hiked its key interest rate by 50 bps. This comes on the back of a 40 bps hike done between the policy meet, taking the total hike of interest rate to 90 bps in five weeks. One basis point is equal to 1/100th of 1%. 

 

The central bank has also hinted at more rate hikes in the coming months to counter high inflation in the economy. 

 

This means that the rising yields of domestic fixed income instruments are expected to rise in the future. Yield is the returns that investment brings in over a certain amount of time. It is shown as a percentage of the amount invested, the value of the security on the market. 

 

Debt mutual fund investors are sitting on massive losses since interest rates are at a historic high. This raises the question of where to invest debt funds in a rising interest rate scenario and how should they invest in this environment. 

 

Let us know more. 

 

Yield versus price problem 

 

The first and the most fundamental thing that debt mutual fund investors should understand is that we cannot compare the lateral movement of yield rise with the equity market. In the case of a rise in yields, there is an inverse relationship with the price of the underlying debt security prices. So when yields rise, they rise because the price of the securities has fallen, and vice versa when yields fall. 

So, in the current situation, the price of securities has fallen as yields have risen. However, there is a disproportionate change in prices and yields across maturity of debt securities. For instance, long-maturity papers become unattractive during such times as investors are locked in for a long duration in such securities. Thus their prices fall more steeply compared with short maturity papers as these will mature sold. Thus new securities with higher yields can be bought in their place to spruce up the portfolio returns.

Investments in short maturity debt funds turn attractive

 

As explained above, short-term debt securities thus are less affected by the yield rise and thus can turn out to be an attractive opportunity for investors in the debt space. An investor can take exposure to space by investing in short-term debt mutual funds and money market funds since these funds invest in short-term papers.

 

Floating rate debt funds

 

This fund can also prove to be an attractive investment opportunity for debt fund investors. Floating rate debt funds invest in securities and structured papers that reset the yield basis the underlying environment and covenants. Thus they are ably placed to provide a higher yield to the portfolio. 

 

Dynamic bond funds

 

Investors who believe that the central banks might not raise interest rates much or would not want to juggle their portfolios regularly as per the changes in the interest rate environment can look at the dynamic bond fund category. These funds, as the name suggests, dynamically alter the portfolio maturity (underlying set of securities) basis the changing situation and thus can move across the yield and duration curve. Therefore, investors do not have to look at moving across various debt fund categories.

 

Summing up 

 

Debt mutual funds provide various options for investors to invest basis their risk-return profile and investment horizon. Investors looking to invest in the short to medium term can invest in debt mutual fund categories outlined in the article above to benefit from the rising interest rate scenario. These funds can not only generate better returns than the traditional fixed income instruments but also give better tax-adjusted returns through indexation benefits for investments beyond three years horizon. It is, however, important to do due diligence before investing. You can contact us to know the suitable debt fund schemes based on your requirement.

This blog is purely for educational purposes and not to be treated as personal advice. Mutual fund investments are subject to market risks, read all scheme-related documents carefully.