The year 2011 rocked for short-term funds. They delivered ahead of other debt categories and turned in the best returns since 2003, if we exclude 2008 as an exceptional year (see Comparing Returns).
In the battle against inflation, the Reserve Bank of India (RBI) continued the trend of rate hikes all through 2011. Last year, the repo rate increased from 6.50 per cent to 8.50 per cent through seven different rate hikes. The yield of the 10-year benchmark paper rose from 7.87 per cent to touch a high of 8.87 per cent. In such a rising interest rate scenario, the yields kept hardening with the rear end of the curve getting more impacted than the front end. For the entire year, it is worth noting that money market yields (below 1 year segment) were higher than bond yields (above 1 year). As a result, higher duration got hammered for most part of 2011.
Naturally, short-term funds maintained a low duration. The average maturity of the category ranged between 0.91 years and 1.51 years. Also, with a liquidity crunch, high interest yield accrued on their portfolios. The combination of lower impact of duration and good accruals helped short term funds outperform last year.
Though liquid and ultra short-term funds are more conservative than short-term funds and offer a much lower downside risk, the compromise is on return. Take for instance, the five-year period ended May 31, 2012, where short-term funds emerge as the best performing debt category with an annualised return of 8.71 per cent.
The upper cap on the average maturity helps these funds deliver returns with lower volatility and preserve capital over long term. If we look at the worst three-month periods, 67 per cent of the funds in this category have managed to deliver positive returns. If we look at their worst one-year period, none have lost any money. The lower average maturity makes them less sensitive to interest rate changes compared to income funds which take more aggressive maturity calls (see Risk Return). Besides the low average portfolio maturity, majority maintain a low exposure to interest rate sensitive papers like G-Secs.
Going ahead what can one expect?
If we look at the year-to-date returns as on May 31, 2012, the category of short-term funds has underperformed the liquid, ultra short-term and income funds categories (see Comparing Returns). Short-term yields remain higher than long-bond yields. However, the tight liquidity conditions in the first quarter of this calendar year pushed up ultra short-term yields (below 3 months). In fact, short-term rates (3 months - 1 year) reached the highest in the past three years. This aided the performance of liquid and ultra short-term funds which got excellent carry in their portfolio.
Though short-term funds also deploy part of their allocation towards accrual, the hardening yields contributed to some loss which the money market funds are generally saved from.
This situation won’t prevail for long. In fact, there has already been some reversal and the one-year yields are already higher than two to three month yields. So one can expect short-term funds to do well once again. Although the long-term picture is still unclear given the huge fiscal deficit, high inflation and weakening currency, it should go in favour of short-term funds. Though uncertainty looms over the extent of rate cuts, the downward movement of interest rate will benefit the funds with slightly higher maturity bets.
Short-term funds may not deliver the kind of returns they did last year, but they remain an attractive and tax efficient choice for fixed income for investors willing to take moderate risk with at least a year’s investment.
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