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Fixed Income: Tweak your debt fund strategy now

Investors with a short holding period and low-risk appetite should now stick to categories like liquid funds of good credit quality portfolios and then shift to long-tenure funds early next year.

Investors with more than two to three years holding period should look at dynamic bond funds which have the flexibility to change the portfolio positioning as per the evolving market conditions.

With rising interest rates, debt mutual fund investors are redeeming their investments from the money market and low to short-duration funds. In May, debt mutual funds reported a net outflow of Rs 32,722 crore after reporting a net inflow of Rs 54,756 crore in April. Higher yields and a preference towards equity have also affected the flows into debt funds.

Data from Association of Mutual Funds in India show money market funds witnessed the highest outflows of almost Rs 14,600 crore, followed by Rs 8,600 crore from short duration funds and Rs 7,105 crore from ultra-short duration funds. Only overnight, liquid and gilt funds witnessed inflows. There has also been a reduction in the number of folios from 73.43 lakh to 72.87 lakh between April and May 2022.

Rising yields

Since the start of 2022, long-term yields have risen over 100 bps and short-term yields have risen by over 150 bps.Analysts say much of the potential rate hikes is already priced in the current bond valuations and the yield spread between the three-year bond (6.94%) over the three-month treasury bill (4.98%) is around 196 bps as compared with its long term 20-year average of around 70 bps. The surge in yields has caused pain to investors who have entered the debt market in the last one year.

Short-term strategy

Experts say as interest rates firm up, investors must look at short-term debt mutual funds now and then shift to long-tenure funds early next year as Reserve Bank of India is expected to increase the repo rate by another 50-75 basis points (bps) by the end of this year, after it hiked the repo rate by a cumulative 90 bps to 4.9% in a little over a month.

For those with short-term investment horizon, floating rate funds would be ideal. Puneet Pal, head, Fixed Income, PGIM India MF, recommends that investors increase their investments in actively managed short duration products while selectively looking at dynamic bond funds as per their risk appetite.

Nitin Shanbhag, head of Investment Products, Motilal Oswal Private Wealth, suggests that for fixed income portfolios, the core allocation should be in high credit quality target maturity debt funds which invest in a combination of G-Secs, SDL, and AAA-rated instruments.

Akhil Mittal, senior fund manager, Tata Mutual Fund, says it would be prudent to invest in shorter duration debt funds as accruals are decent and duration risk is contained. “Upward shifting of overnight rates bodes well for floating rate funds. Floating rate bonds may benefit from rate hikes as accruals go up while effective duration remains very low. So high predictability and lower volatility could make floating rate funds a well-suited choice in current times,” he says.

Investors with more than two to three years holding period should look at dynamic bond funds which have the flexibility to change the portfolio positioning as per the evolving market conditions. However, they may face some intermittent volatility in the portfolio value. In fact, medium-to-long-term interest rates in the bond markets are already at long-term averages as compared to fixed deposits which remain low.

Potential for liquid funds

After the sharp jump in bond yields since January, the returns potential of liquid debt funds has improved significantly. Pankaj Pathak, fund manager, Fixed Income, Quantum Mutual Fund, says the gap between the bank savings rates and liquid fund returns will widen and remain attractive. “Investors with a short holding period and low-risk appetite should stick to liquid funds or good credit quality portfolios,” he says.

Keeping up with the rate hikes

* Core allocation should be in high credit quality target maturity debt funds

* For those with short-term investment horizon, floating rate funds would be ideal

* Look at dynamic bond funds if you plan to hold on for more than two to three years

* The returns potential of liquid debt funds has also improved significantly

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