In our previous articles, we talked about the volatility in the debt market amid the ongoing pandemic. With a spike in bond yields since the start of this year, several debt funds delivered subdued or negative returns over the short term. The subdued returns have made investors cautious and left them wondering what their debt-fund strategy should be in the future.
In a bid to counter the risk of rising yields, the first few steps should be to avoid long-duration bonds, avoiding credit risk funds and opting for target maturity funds. Let's see another option that you can explore.
Short-duration funds: The all-whether category
Given the risk of rising yields, short-term categories like banking and PSU debt, corporate-bond funds and short-duration funds remain a good choice. While short-duration funds are mandated to maintain a Macaulay duration of one year to three years by mandate, majority of banking and PSU debt funds and corporate-bond funds also usually have maturities of up to three years. Given the relatively shorter maturity profile, the impact of rising rates will be limited here.
Also, when short-term rates increase progressively, these funds can start yielding better as they are able to incrementally invest at better yields. In fact, we can already see a slight uptick in the yield-to-maturity across several short duration funds (look at the chart 'Return expectations from short-duration funds').
However, the returns that we saw in the last couple of years are a thing of the past and investors should moderate their return expectations now.
Let's now compare short-duration funds with target-maturity funds. As stated above, most target-maturity funds that are being launched are taking into account a five- to seven-year timeframe. To see how short-duration funds have performed over this kind of timeframe, we looked at the category's median returns in any six-year period in the last 15 years. See the chart 'Short-duration funds' resilient performance'. Our analysis shows that in any six-year period, short-duration funds have mostly delivered better returns than the 6-6.5 per cent that some of the target-maturity funds are offering over this horizon. The minimum returns these funds have seen is about 6.20 timeframe, we looked at the category's median returns in any six-year period in the last 15 years. See the chart 'Short-duration funds' resilient performance'. Our analysis shows that in any six-year period, short-duration funds have mostly delivered better returns than the 6-6.5 per cent that some of the target-maturity funds are offering over this horizon. The minimum returns these funds have seen is about 6.20 not ignore the fact that there is no visibility of returns at the outset in the case of short-duration funds.
Next, we checked how the spreads of the returns of these funds have been with respect to inflation. As can be seen from the graph 'CPI vs short-duration funds', the spread has been considerable and more stable after the adoption of the inflation-targeting framework of maintaining 2-6 per cent rate of inflation in 2016. This inflation target recently came up for review and the government has decided to retain the target band of 2-6 per cent. Since the RBI will work towards anchoring inflation and inflation expectations around the target, we can expect these funds to continue to have a reasonable spread over inflation in a fairly steady manner. These funds should deliver similar or even better returns from here, given that their portfolios will benefit from rising rates.
Clearly, short-duration funds remain the best debt funds to invest in. And that's not so in this scenario alone. These funds are capable of becoming the core of a debt portfolio. However, be diligent in picking the ones that don't take much credit risk. The duration risk is already capped in these funds at the fund level.