Joker in the pack could be inflation! Impact on debt fund investments and where to invest

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July 30, 2021 11:53 AM

For fixed income investors it is wise to choose a fund which is dynamic and can capture the interest rate movements which are in line with inflationary trends.

Inflation impact on debt fund investmentsIt is better to be in a fund, which has a floating rate and can manage the shocks to interest rate yield curve in the portfolio.

There are plenty of debt fund investment options. In fact, there are 16 categories of debt funds to choose from. But, before investing in debt funds, which suit goals that are within 3 years to meet, you need to be aware of the factors that impact their returns. Besides, the credit risk of bond issuers, the role of inflation and interest rates are equally important.

A look at how the debt funds are faring: The average return of Long Duration debt funds is about 2.76 per cent over the last 12 months. Compared to that, the Short Duration and Medium Duration returns are close to 4.43 per cent and 6.25 per cent, respectively. And, the returns of floating debt funds is nearly 5.31 per cent.

When the inflation seems to be rising in the economy, there is a direct and immediate impact on the bonds, in turn on your debt funds.

The bond price tends to fall with the expectation that newer bonds will be available with a higher coupon rate. And, when the bond price falls, the yield i.e. effective return of holding it till maturity, sees an increase. Therefore, in a rising inflation scenario, bond yields increase expecting a rise in the interest rate in the near future, at least.

Simply put, when bond yields start climbing, there’s a pressure on the rates and any further rise gets arrested. Whether it moves up is a function of other factors including how the central banks manage the monetary environment.

Presently, inflation is looking to make a comeback in the economy. “There’s been a sort of a double whammy – one, low interest rates causing savings rates to drop and this leading to excess liquidity causing the prices of assets and commodities to shoot up and, therefore, creating inflation and secondly, supply side being impacted due to logistics and due to lock downs and extended lockdowns,” informs Santosh Joseph, Founder and Managing Partner, Germinate Investor Services LLP.

This makes debt fund investors take stock of the situation and plan their investing moves carefully. Overall, due to rising inflation and corresponding rise in yield, the impact on the short term-medium term and the long term interest rates may vary.

“We know that when inflation is trending higher, rates will either stay put or even the short to medium term rates tend to inch higher, therefore, putting some of your medium term to long term funds at risk. Some short term funds will be initially at risk. So, therefore, it’s very important on what end of the curve an investor chooses. It’s not going to be an easy scenario where you just put money in and you make money, because inflation is going to be really the joker in the pack,” says Joseph.

Generally, short to medium term debt funds become the first choice in a rising yield environment. But, the trend may not be easier to catch early-on. “So, for fixed income investors it is wise to choose either a fund which is dynamic and can capture the interest rate movements which are in line with inflationary trends. Second, it’s also better to be in a fund, which has a floating rate and can manage the shocks to interest rate yield curve in the portfolio,” suggests Joseph.

“In the given scenario, there is more promise for someone looking at a three to four year horizon than someone who’s looking at a one to two year horizon because things are a lot more stable in that time period,” adds Joseph.

No matter which asset class you choose to invest in, the aim is to beat inflation. “Position your portfolio to be able to beat inflation, hedge inflation and eventually make money,”advices Joseph.

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