It's time to move primarily into short-term funds

With the benchmark 10-year government bond yield rising above 7%, the larger part of your debt portfolio should be in short-term funds having a sound credit profile

The one-week average returns of most long-term debt fund categories have turned negative: Gilt medium and short term (-0.32 per cent); dynamic bond (-0.18 per cent) and income funds (-0.13 per cent), according to Valueresearchonline.com. This has been caused by a spike in interest rates, with the yield on the 10-year government bond rising from 6.73 per cent to 7.06 per cent over the past month. After this spike, investors need to re-examine their debt fund strategy.

Several factors are responsible for the rise in interest rates. The price of crude oil has risen in the international markets owing to events in Saudi Arabia. There are also fears that the government may overshoot its fiscal deficit target of 3.2 per cent, owing to changes in GST rates, causing it to borrow more from the markets. Globally, too, interest rates are rising: Rates in the US are close to 2.5 per cent now. Both CPI-based inflation (3.58 per cent) and WPI-based inflation (3.59 per cent) moved up in October compared to the previous month. 

Whether interest rates will continue to rise will depend on the price of oil and the government's fiscal deficit. "I expect interest rates to rise over the next three to six months before they stabilise," says Mahendra Jajoo, head of fixed income, Mirae Asset Global Investments. According to Prashant Pimple, senior fund manager-fixed investments, Reliance Mutual Fund, "Most of the negatives are priced in. The expectation was that yields would move up to 7.10 per cent and they have already moved to 7.06 per cent." He adds that clarity on fiscal deficit will provide a clue regarding the future direction of interest rates.

At this point, the larger portion of your debt portfolio (70-80 per cent) should be in short-term debt funds, having a modified duration of one to three years. A small portion may be kept in longer-duration funds. "If you have a long investment horizon and the necessary risk appetite, you may still invest a part of your corpus in longer-duration funds. After all, nobody can predict where interest rates will be three or five years from now," says Jajoo. He adds that those with an investment horizon of three years or more may do an SIP in longer-term debt funds, thereby averaging the yield at which they purchase units of these funds (just as you do an SIP in equity funds to average the purchase price). Investors who had entered long-term bond funds expecting windfall profits in the short term due to a decline in interest rates should exit them. 

Investors wanting to select a short-term bond fund should look at its modified duration and credit profile. "The modified duration should be between one and three years. As for the credit profile, the portfolio should consist largely (80-90 per cent) of triple-A bonds," says Kaustubh Belapurkar, director-manager research, Morningstar Investment Adviser India. Jajoo suggests that right now you should invest in a fund with a duration of one to one-and-a-half years, which will have the least volatility. Investors should also avoid chasing past returns in these funds. Funds that have given very high returns in the past may have done so by investing in lower-rated papers. Instead, look for a consistent performer over the long term. Finally, go with a fund having a low expense ratio. 

Pimple suggests investors who are prepared to take a little extra risk may invest in credit-oriented funds. These funds should have an average maturity between one and three years. They try to give you higher returns by investing in lower-grade bonds. Given their riskier character, they should constitute only a small portion of your debt fund portfolio.