In the past week, yields in the debt market have risen due to Covid-19-driven fear. A jump in yields causes prices of bonds to fall because of which most debt funds suffer. Debt funds at the short end of the spectrum such as liquid or ultra short-term funds are not considered very sensitive to such shocks. However, in the past week, even these categories took a hit. We spoke to experts about why this happened and what should investors do.
Rajeev Radhakrishnan, head, fixed income, SBI Mutual Fund, noted two reasons for the spike in yields. “First, investors prefer to hold more cash at year end and that requirement has gone up due to the current volatility. Second, stay-at-home working and organizational disruption have reduced the dealer presence in the market," he said. Financial firms based in India’s economic capital of Mumbai have been asked to introduce work from home policies for their staff to contain the spread of Covid-19.
Debt funds in the very short duration segment do not see much volatility in their returns on account of the short maturity of the papers they hold. The yields in this segment are, typically, not subject to significant spikes or drops. This, combined with the low maturity of the securities that these categories of funds hold, means smaller changes in the value of the securities and thus, a steadier ride for investors.
The Securities and Exchange Board of India (Sebi) allows liquid funds to only hold papers with up to 91 days maturity. Ultra short duration funds must keep their Macaulay duration (a measure of interest rate sensitivity) between three and six months; low duration funds must keep their Macaulay duration between six months and one year; and money market funds are allowed to invest in papers with residual maturity of up to one year. This whole set of debt funds is bound by regulatory rules to minimize interest rate risk, or the risk of volatility, in the values of the securities held in the portfolio, and consequently in the net asset values of these schemes. The higher the duration of a fund, the greater is the interest rate risk and vice-versa.
The uptick in the yield has led to lower security values and this has eaten into the returns from these funds. On average, liquid funds have delivered nil returns over the past week, according to data from Value Research, as on 22 March. In fact, many large liquid funds have delivered negative returns. Ultra short duration funds have given -0.40%, money market funds have given -0.48% and low duration funds have delivered -1.10%. These are categories that normally do not deliver negative returns even over short time periods and are considered extremely low on risk. Investors use these funds for parking money that they require for immediate needs, including systematic investments, and short-term goals, or when they are unsure of when they may need the funds.
Categories of debt funds with longer durations have taken larger cuts, but this kind of interest rate or duration risk from rising yields is common among them.
What you should do
One way for investors who have very short time horizons to cut this type of risk is to invest in overnight funds. They invest in papers maturing in a single day and, hence, carry virtually no interest rate risk.
However, they offer a much lower yield. They were giving around 4.5%, as on 22 March. Debt fund managers have cautioned investors against moving to overnight funds in reaction to the current transient scenario. “The average yield difference between overnight and liquid funds is about 1.5%. So anyone with a horizon of 30 days or more would be equal or better off in liquid funds even if yields rise by up to 3% assuming 45 days’ liquid fund duration," said Dwijendra Srivastava, chief investment officer, debt, Sundaram Asset Management Co. Since a 3% jump in yields is an extremely rare occurrence, investors will be better off in liquid funds. “Those with shorter time horizons should stick to overnight funds," added Srivastava. Radhakrishnan concurred. “Investors need not switch from liquid to overnight for any time horizon more than a few days. We expect some sort of market intervention to bring down the yields soon," he added. According to media reports, the Association of Mutual Funds in India has written a letter to the Reserve Bank of India asking it to extend a liquidity window to mutual funds to help them meet redemptions. These redemptions have been running at over ₹50,000 crore per day for the past few days, said the letter.
Investors should not unduly panic because of what is a very rare occurrence. Pick your debt category as per your time horizon and the duration risk in the fund (captured by modified duration). If your time horizon is less than one week, you can look at overnight funds.
While selecting a scheme from the basket of liquid, ultra short and low duration categories, look at three parameters. First, the fund’s modified duration. The lower the modified duration, the less is its sensitivity to interest rate changes. Second, credit quality. Credit risks are not confined to credit risk funds and exist even at the short end of the curve. So look at funds carrying high levels of AAA (or equivalent) rated papers or those with PSU rather than private sector debt. But concentrated allocations to a particular issuer or sector should raise red flags. Third, stick to funds of a relatively large size as they are better able to diversify and hold less concentrated portfolios. They are also less susceptible to sudden and large outflows in times of market panic.