Your Queries – Mutual Funds: Medium end of the yield curve looks attractive now

Cash needed for near-term expenses is typically parked into liquid and ultra-short-term funds.

Mutual Funds investment
Longer duration funds witness a higher fall in value than shorter duration funds for the same rise in inte

As interest rates are rising, should I invest in liquid funds for the short term without taking a long term exposure in any funds?
— Piyush Sharma

Bond prices are inversely related to interest rates, i.e. as interest rates rise, bond prices fall and vice versa. Additionally, higher the duration of a bond, the greater is the mark-to-market loss during rising interest rates and vice-versa. Recently, the interest rate cycle turned a corner and is now on the upswing. The sovereign yield curve has seen an upward shift and has also flattened somewhat following a sharper rise in yields at the shorter end amid measures by the RBI such as repo rate hike, CRR increase, lowering of systemic liquidity, etc., in response to concerns over inflation and monetary tightening by global central banks.

Longer duration funds witness a higher fall in value than shorter duration funds for the same rise in interest rates. Hence, investors typically tend to gravitate towards lower duration portfolios when they anticipate rates to rise. However, market-to-market loss depends on the quantum of rate increase and the duration of the bond portfolio. Hence, expectations of the quantum of rise in interest rates at various segments across the yield curve play a key role in taking positions from a duration perspective. As we have very recently witnessed, the rise in rates at the shorter end (1-2 years) has been much sharper than that at the longer-end (over seven years) of the yield curve.

In case of very short duration funds such as liquid funds, a portion of the portfolio gets matured periodically which then provides cash to re-invest at the then higher rates given the rising rate scenario. Hence, these funds benefit as their accrual rate is somewhat aligned to the rise in interest rates at the shorter end of the curve. Cash needed for near-term expenses is typically parked into liquid and ultra-short-term funds. One should also be cognizant of the risk-reward on offer across positions on the yield curve and be adequately diversified at various segments in line with their risk-appetite. Currently, the medium end of the curve looks attractive from a risk-reward perspective, offering attractive yield pick-up (~2.5%) relative to the very short end.

(The writer is director, Investment Advisory, Morningstar Investment Adviser (India). Send your queries to fepersonalfinance@expressindia.com)

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