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How do short-term debt funds manage interest-rate risk and credit risk?

Given the mandate on duration here, the impact of interest-rate movements is range-bound but different funds can differ much on the credit-quality, says Ashutosh Gupta

VR recommends short-term debt funds for a duration of more than one year. Please explain how these funds manage interest-rate and credit risks? Recently, they are showing negative returns. Also, suggest alternatives to it for capital protection.
- Pratap

As far as the interest-rate risk is concerned, it's fairly range-bound in the case of short-duration funds because by the regulatory mandate, they have to maintain the duration of their portfolio between one year and three years. Now typically what happens is that the interest-rate risk happens to be higher in those funds that invest in longer-tenured bonds and those are the ones which witness more ups and downs in their value in response to changes in the interest rates.

Since short-duration funds have to keep their duration in a short range, that's why the impact is fairly limited. As the events have unfolded since the start of this year, yields have moved up, because of which, debt funds have delivered negative returns as you have rightly pointed out. But the magnitude of negative returns has differed across different debt categories. The gilt funds are among the most impacted ones having lost over 1 per cent or higher. Dynamic bond funds, for instance, have seen negative returns of about 0.8 per cent, while short-duration funds have shown negative returns of about 0.5 per cent. Now, this is fairly in line with the kind of average portfolio maturities these kinds of funds maintain. So, the impact of interest-rate movements in short-duration funds is fairly narrow and range-bound in comparison to some of the other categories which invest in bonds of much longer duration.

With regard to the credit risk of short-duration funds, that is where there is no regulatory mandate on these funds. So, different funds can differ significantly in the credit-quality domain. If you look at the current portfolio of these funds, then all appear to have a fairly high-quality portfolio in terms of credit ratings of the bond they invest in. But that is not the case always. If we travel back in time a bit, we would spot wide differences in the credit quality of the portfolios. Some funds were taking aggressive credit calls by investing heavily in lower-rated bonds. So that's an aspect which investors would need to monitor periodically. In fact, the newly revamped risk-o-meter unveiled by SEBI can help investors understand the element of risk in their funds and track it on an ongoing basis.

Coming to the second part of the question, while over shorter time frames of a few weeks to months, short-duration funds can witness volatility and negative returns in response to interest-rate movements, they are generally suitable for an investment horizon of over one year.

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