These debt funds can help you counter RBI's rate hikes

Risk-averse investors shouldn't lose hope. There are oases amid the chaos.

These debt funds can help you counter RBI’s rate hikes

A brief background
India's debt markets have witnessed intense volatility in the last few weeks as the Reserve Bank of India (RBI) has been hiking interest rates to tame high inflation.

And the pain is yet to subside any time soon. Experts forecast the RBI to raise interest rates by another 50 basis points (which is 0.5 per cent) this week. This would be over and above the 1.4 per cent rate hike that they have already administered.

While the overall borrowing rate is currently at 5.4 per cent (without factoring in the expected rate hike this week), experts estimate it to eventually settle at around the 6.5 per cent mark, as reiterated by Murthy Nagarajan, the head of fixed income at Tata Mutual Fund.

Impact of rising rates on bonds
Rising interest rates reduce the price of existing bonds.

We are talking about bonds now because debt funds invest heavily in them.

Returning to why rate hikes lower bond prices, let us explain how: bonds pay a fixed coupon (interest payment) to investors. But if RBI increases interest rates, the new bonds issued after that will promise higher interest payments. As a result, demand for existing bonds falls, and so does their price. Lower the demand, lower the price.

This is basically why debt markets have been chaotic in recent weeks.

The solution
In such a scenario, you can avoid debt funds that will take six to 10 years to mature. In other words, we should restrict ourselves to debt funds that will mature (repay our entire investment) in three to five years' time. By lowering the maturity duration, you are shortening the risk of higher interest rates.

What experts say
Debt fund managers suggest investors can look at the following debt fund categories:

Pankaj Pathak, the fund manager of fixed income at Quantum Mutual Fund, said: "We maintain our view that the worst of the bond market sell-off is now behind us... the 3- to 5-year segment remains the best play as core portfolio allocation."

"The long end of the yield curve is vulnerable to an adverse demand-supply shock. However, any mispricing in this segment can be exploited through tactical positioning from time to time," he said, technically referring to long-duration bonds being prone to interest rate hikes and how he may look at these bonds only when right opportunities arise.

Nagarajan also batted for debt funds with a three to five-year maturity. "Target-maturity funds or short/medium-duration funds could turn out to be good options. If investors are looking to hold till maturity, target-maturity funds that will mature in the next five years look very attractive."

What are target-maturity funds?
In the last few years, investors have taken a shine to this category as they offer some degree of predictability in returns.

Target maturity funds come with a fixed tenure, and at the end of fund life, the money, along with the accumulated gains, is returned to the investors.

There is no active management here, as the fund manager simply buys and holds securities with maturities similar to the term of the fund. This means you pay a low commission (known as expense ratio).

In addition, these funds invest in top-quality papers issued by the central government, public sector undertakings (PSUs) and state governments. As these investments are mandated to be "AAA" in nature, there is a fairly low possibility of any defaults.

Also, they are not much impacted by interest rate movements when compared to other debt funds as they follow a roll-down strategy. Roll-down strategy is just another way of saying that these funds hold the securities they invest in until maturity.

What are short-duration funds?
These funds typically have a maturity period of one to three years.

The average maturity of short-duration funds is currently 2.15 years, with a yield to maturity of approximately 6.74 per cent.

As explained earlier, having lower-duration funds will minimise the impact of higher interest rates, and there will be low volatility in such funds.

Investors should hold these funds for three years because the gains are treated as long-term capital gains and are taxed after indexation. Indexation helps reduce your tax liability.

Suggested read: The evolution of target-maturity funds

Other Categories