Home / Mutual Funds / News /  Short-term debt funds find themselves in a sweet spot

Investors looking for cues from the Reserve Bank of India’s (RBI) credit policy on what they can expect for their debt portfolios got some good news and some not so good news.

Those wanting to park their money for very short investment horizons in liquid and money market mutual fund schemes are likely to see some fall in returns as interest rates on debt instruments in which these funds invest, such as commercial papers and certificates of deposit, decline in response to policy rates. This impact may be seen on returns going ahead as funds make new investments at lower coupon rates. In the immediate future, the impact on returns will be less noticeable as tight liquidity in the March quarter is likely to keep interest rates high on these instruments and returns are likely to remain at current levels.

Investors in mutual fund products such as low- and short-duration funds are in a sweet spot since these funds are likely to benefit the most from the rate cut. While a reduction in interest rates will bring down the interest income earned by the fund when it invests in new bonds with lower coupon interest, this is made up for by capital gains from an increase in the price of the existing bonds in the portfolio. This is because the old bonds with higher coupon rates will now be more valuable than new bonds that will be issued at lower prevalent rates. The interest income the fund earns is boosted by the capital gains, thus increasing the total returns from the fund.

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“Fixed income will cheer the rate cut accompanied with change in stance from calibrated tightening to neutral. This would keep the door open for one more rate cut in the future. Moreover, liquidity conditions are also expected to improve into the next quarter. These factors augur well for short end rates to remain stable. Hence, we recommend exposures in funds operating in 1-3-year segment," said Saurabh Bhatia, vice-president and fund manager, fixed income, DSP Investment Managers.

But these benefits are unlikely to transmit to longer-term bond funds. This is because despite the rate cut, long-term interest rates are likely to remain high as a result of the large borrowing program of the government to finance the high fiscal deficit. “There are worries about G-sec supply being quite large in the next year and the total volume of RBI open market operations being less," said R. Siva Kumar, head, fixed income, Axis Asset Management Co. Ltd. Just as lower interest rates result in capital gains for existing bonds, interest rates going up will result in capital loss for the existing bonds with lower coupon rates as they become less valuable. The capital loss eats into interest income earned by the fund, reducing the total returns.

Should investors see the credit policy as signaling a period of lower rates going forward? Not yet, say experts pointing to the steep government borrowing and other structural issues that first need to be addressed.

What you should do

Mutual fund investors should stay with funds with shorter investment horizons such as low- and short-duration funds that are likely to benefit the most from the current rate cut and any cuts in the future. Liquid funds will continue to serve the purpose of being a low-volatile vehicle to park funds for very short periods.

Investors looking for the safety and predictability of fixed returns should look at small savings schemes that seem attractively positioned on the returns scale. If the G-sec yields go up as expected, given large government borrowing, these schemes whose returns are pegged to G-sec yields will also see an increase. As inflation comes down, higher real returns from these schemes will make them more attractive.

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