Short term debt funds are in demand: Where should you park your funds?

Active debt funds,  where the fund manager buys and sells bonds based on assessment of interest rates, prevailing yields and credit risk, dominated the monthly flows in both April and May 2023, dwarfing flows into equity, hybrid and passive funds. 

After seeing net inflows of Rs 106,677 crore in April, debt funds saw another fruitful month with net inflows of Rs4 5,959 crore in May 2023. The hike in the repo rate by the RBI over the past year has benefited short duration debt funds. Liquid funds have, on an average, given a return of 6.15 per cent over the past year.

As interest rates have peaked, investors appear to be locking their investments in shorter-duration debt funds  and liquid funds at the prevailing high rates.

How do interest rates impact debt funds?

Bond prices and interest rates are inversely correlated. and  when interest rates go up or are expected to go up, prices of existing bonds fall and vice versa. The prices of existing bonds fall as the newer issues of bonds for the same tenure will carry higher interest rates.  The longer the duration of an instrument, the higher is the sensitivity to interest rate changes.

Market prices of debt securities change with movements in interest rates. If your debt fund owns a security that yields 10 % interest, then when  the interest rate in the economy falls, new instruments issued in the market would offer this lower rate. To match this lower rate, there would be an increase in the prices your fund’s underlying instruments as they have a higher coupon (interest) rate. As a result of the increase in the debt instrument’s value, your fund’s NAV, too, would increase.

When interest rates are high, the impact is higher on medium to longer duration papers than on shorter duration papers. This is because the price fluctuation is much lower in short-term debt papers than in bonds of higher duration. Debt mutual funds investing in short-term papers tend to perform better in a rising interest rate scenario, while medium to long-duration papers can sometimes witness a correction.


What is happening currently?

With returns of nearly 8%, debt mutual fund schemes have become the flavour of the season as investors are shying away from equity schemes due to the volatility in the market and seek stability from unpredictable fluctuations. 
 

There were several categories of debt funds that saw big inflows in May 2023. Liquid funds saw inflows of Rs 45,234 crore, Money Market funds Rs8,731 crore, ultra short duration funds Rs7,585 crore, and short duration funds Rs 4,055 crore.

"The return of debt funds appears to be a reset of institutional allocation, as well as locking in higher rates," said brokerage IIFL. May 2023 was again dominated by debt funds, although its share has not gone up too  much over April. "That is because the stock market appreciation led to a spike in the share of equity funds too. In fact, hybrid funds and passive funds saw their market share fall in the last two months, as flows have been muted and they have not gained much from index highs," said the brokerage.

"In the last two months, fixed income funds have seen an inflow of about Rs 1.50 lakh crore, while equity funds have only witnessed inflows of close to Rs 10,000  crore.  Equities are trading at a forward earning Price/Earnings ratio of 23 times, which is expensive, even by historical comparisons. Many investors do not believe that equities are likely to give a return of  8-10% in a year from current levels," said Sandeep Bagla, CEO, Trust Mutual Fund.

Meanwhile, interest rates have risen in the last few quarters by more than 200 basis points. An investor can easily earn 7-7.50% in highest rated debt instruments."From a risk reward perspective, the fixed income appears to be a safer bet to investors, it seems. Additionally, with central banks threatening to tighten liquidity conditions further, there is a distinct danger of an equity market correction as well," said Bagla.

What kind of debt funds should you choose?

Data anlysed from Association of Mutual Funds India ( AMFI) shows  maximum net positive inflow has been in Liquid Fund, Ultra short term fund, Low duration, Money market and Short duration funds. In fact the long duration fund categories like Dynamic Bond fund, Credit risk fund, Government of India Securities fund (Gilt) and Floater fund has seen net negative flows.

"This data clearly reflects that investors are staying away from long duration fund and putting money in short duration fund due to flattening of yield curve. In general investors and wealth managers feel that we have reached upper end of the interest rate cycle and rates will not go up from here. They also feel that due to global pressure and concern over domestic inflation with monsoon season coming up, interest rate will not go down hence they are not committing investments to long duration products," said Jayesh Faria, Director, Regional Head – West, Motilal Oswal Private Wealth.

Currently yields across debt funds continue to be at a relatively high  and if an investor's investment tenure is long term, then at current interest rate scenario, she should lock investments on long-duration through dynamic bond funds, advised Gurmeet Singh Chawla, Director, Mastertrust .

RBI is commited to bringing down inflation to 4% and if inflation continues to trend downward, it is unlikely that RBI will hike rates. This augurs well for debt funds. The increased possibility of stable and downward trending interest rates in the near future, makes debt funds an attractive avenue to invest.

"Debt mutual funds are an excellent way to get exposure to quality debt assets. Over the last three years, the retail holdings of debt mutual funds have grown at around 35% CAGR. The primary reason for this growth is the high-interest rates in the country due to retail inflation-related concerns. However, The finance ministry has amended the Finance Bill 2023 to remove the indexation benefit for debt mutual fund schemes from FY24. Post this, returns from debt mutual funds will become at par with corporate bonds. Thus, many retail investors who earlier invested in debt mutual funds will now be open to exploring corporate bonds too," said Ajinkya Kulkarni, Co-Founder and CEO, Wint Wealth.

Where should investors park their funds?

"The 10-year benchmark bond will trade in the range of 6.90% to 7.15% in the medium term. The short end of the curve is expected to correct the most when RBI starts its rate cut cycle. An ideal investment portfolio should invest across the curve as the shorter end provides high accrual with lesser duration risk. The longer end of the curve, however, provides higher potential of capital gains but with increased duration risk.

The lopsided allocation can be made basis investor risk appetite. However, for a long-term debt investor, it would be ideal to invest in short-term and corporate bond funds as these have potential of both higher accruals and higher capital gains," said Anand Nevatia, Fund Manager, Trust Mutual Fund.

In a high interest rate environment with flat yield curve, it is ideal to remain invested at the short end, hence Ultra Short term Funds and Arbitrage funds which offer tax efficient returns are ideal for short term parking upto 6-12 months, according to ICICI Securities.

 "The yields in 3-5 years AAA corporate bond/SDL segment have fallen since March end, however yields still remain attractive and are trading around 7.4-7.5%. Hence, exposure to actively managed corporate bond Fund/Gilts Fund will offer decent accrual yields with an investment horizon of 3 years and above," it said. 

Also, Blended/Medium Term fund with a balanced exposure to decent quality AA and AAA assets is also likely to generate good carry returns with a time horizon of 3 years and above. Further, funds which offer indexation benefit as per new taxation laws are being launched by AMCs, should be considered as part of new long term (>3 years) debt allocation.

ICICI Securtities recommends that investors should allocate 20% of their debt portfolio in short-duration funds like the Nippon India Short Term Fund and Kotak Bond Short Term Fund, and another 10 percent in a corporate bond fund like HDFC Corporate  Bond Fund. "These funds run an Accrual Strategy where it offers a blended portfolio of sovereign, AAA and AA to capture spreads available across the segment," it said. 

The brokerage also recommends investors to allocate 15% of their portfolio towards gilt funds. " Rising rates have presented an excellent opportunity to start allocation to longer maturity G-secs and lock-in interest rates."

At least 20 percent should be allocated towards a Dynamic Bond Fund because based on interest rate scenario, the scheme toggles between credit risk & duration risk. Such schemes increases duration when interest rate is expected to fall to benefit from capital appreciation; and reduces duration when interest rate is expected to rise to mitigate risks from marked-to-market losses.

ICICI Securtities also recommends investing 15% in a multi asset fund. " Unique fixed income opportunity in the new Tax category for mutual funds (i.e. having allocation to Equity between 35%-65%) and therefore eligible for lower LTCG Tax (20% after Indexation) if held for 3 years, compared to other fixed income products including debt mutual funds which are taxed at the Marginal tax rate irrespective of holding period," it said.