Invest bulk of debt portfolio in funds that have 2-5-year average maturity

Avoid exiting from the category as most of the pain caused by rate hikes is behind us

 Debt mutual funds have seen outflows in four of the past six months ending January 2023. Cumulatively, they have witnessed outflows worth Rs 27,473 crore over this period, according to data from the Association of Mutual Funds in India (Amfi). In January, they lost assets under management worth Rs 10,316 crore.

While liquid and overnight funds (which corporates enter and exit according to their needs) accounted for the bulk of outflows, other categories too have lost funds.

One reason is that the Reserve Bank of India (RBI) has been hiking the repo rate since May 2022. “Investors withdrew money from several debt fund categories to mitigate the mark-to-market (MTM) impact,” says Vikas Garg, head of fixed income, Invesco Mutual Fund.

Prior to the 2023-24 Budget, there were concerns that the government’s borrowing programme would be heavy and would exert pressure on yields. This led to outflows in January.

Past returns of debt funds look poor in a rising interest-rate scenario. “Those numbers may have also led some investors to exit,” says Kunal Valia, chief investment officer, listed investments, Waterfield Advisors.

A good time to enter

Experts say instead of pulling money out, retail investors should enter debt funds at this juncture. “We are close to the peak interest rate. Investors can gain from the high yield to maturity (YTM) prevailing across fund categories,” says Garg. High YTMs will translate into high accrual returns.

While interest rates are likely to stay elevated for some time, the rate cycle will turn eventually. “By investing with a three-four-year horizon, investors can reap the benefit of long-term capital gains (LTCG),” says Valia.

Those who invest for more than three years will also be taxed favourably: LTCG from debt funds (on units held for more than three years) is taxed at 20 per cent with indexation benefit.

Where should you invest?

Arnav Pandya, founder, Moneyeduschool, suggests that investors should select debt fund categories based on their goal and investment horizon. The investment horizon should be equal to or slightly less than the average maturity of the selected category.

Currently, the middle of the yield curve is most attractive. Says Sandeep Bagla, chief executive officer, TRUST Mutual Fund: “Those who have an investment horizon of three years or more should go for categories like corporate bond funds, banking and public sector undertaking funds, and short-duration funds.”

Garg is of the view that currently 75-80 per cent of an investor’s debt fund portfolio should be in the two-to-five-year bucket. “These categories should form an investor’s core allocation. The balance 25-30 per cent should be invested in categories that can limit downside risk, such as ultrashort duration funds and money market funds,” he says. He adds that at an opportune time, the 25-30 per cent can be switched to longer-duration funds to benefit from capital gains opportunities.

Those who have a 6-12-month horizon should also stick to categories like ultrashort duration and money market funds.

Mistakes to avoid

Fund managers say spreads are not attractive enough to warrant investing in AA- and A-rated papers. Besides credit, these papers also carry liquidity risk. “From the risk-reward perspective, it is prudent to stick to schemes that invest in the highest-quality papers, such as G-Secs, state development loans, and AAA corporate bonds,” he says.

Longer-duration funds may be avoided for now. “We are still in the final leg of volatility. Better points for entering into longer-duration categories will become available in the future,” says Garg.

Pandya suggests that investors who have a longer investment horizon should use target maturity funds of matching maturity.

The latest CPI-inflation figure has created some uncertainty. Says Pankaj Pathak, fund manager-fixed income, Quantum Mutual Fund: “But inflation has been coming down sequentially and disinflation is visible across many goods and services. So, we may possibly have seen the peak of this rate cycle already at 6.5 per cent.”

With most of the pain from rate hikes behind us, avoid pulling money out of debt funds. Pandya says investors should avoid panicking due to short-term movements in yields caused by inflation delivering negative surprises.