Inflation is running amok and impacting almost all asset classes. To keep inflation in check, RBI has been increasing the repo rate, thus making money dearer for banks. In turn, interest rates keep increasing as money supply gets constrained. After the two consecutive repo rate hikes, the impact on the short-term interest rates was much quicker.
“The interest rate on short-term treasury bills has jumped about 1.6% in the last 6 months. With more rate hikes coming, short-term treasury bill rates are expected to move higher in the coming months. This suggests higher potential returns from investments in liquid and debt funds going forward,” says Pankaj Pathak, Fund Manager- Fixed Income, Quantum Mutual Fund.
In such an environment, when the stock market is tumbling and gold prices are flat, investors look for investment options to earn a positive return on their funds. Debt funds provide an opportunity to not only keep the funds liquid but also generate effectively high returns. However, not all categories of debt funds may be suitable in a rising interest rate scenario.
There are about 16 different categories of debt mutual fund schemes based largely on the maturity profile of their underlying securities. “Since the interest rates on bank saving accounts are not likely to increase quickly while the returns from liquid fund are already seeing an increase, investing in liquid funds looks more attractive for your surplus funds. Investors with a short-term investment horizon and with little desire to take risks, should invest in liquid funds which own government securities and do not invest in private sector companies which carry lower liquidity and higher risk of capital loss in case of default,” says Pathak.
The risk in debt funds including liquid funds may still exist as NAV may show intermittent volatility as the interest rate scenario remains dynamic. To be on a safer side, look at the portfolio of the liquid fund before investing. “Investors with a short-term investment horizon and with little desire to take risks should invest in liquid funds which own government securities and do not invest in private sector companies which carry lower liquidity and higher risk of capital loss in case of default,” cautions Pathak.
Dynamic bond funds also play an important role to generate higher returns in the current interest rate scenario. “Investors with more than 2-3 years’ holding period can consider dynamic bond funds which have the flexibility to change the portfolio positioning as per the evolving market conditions,” adds Pathak.
Dynamic Bond Funds are debt mutual funds that do not have any restriction with regards to duration or maturity of the securities they invest in.
But, what makes dynamic bond funds a better bet in these times? Pathak explains, “Medium to long-term interest rates in the bond markets are already at long-term averages as compared to fixed deposits which remain low. With higher accrual yield (interest income) and relatively lower price risk (compared to last two years), dynamic bond funds are appropriately positioned to gain.”