Volatility is no stranger to debt markets. As interest rates have moved northwards, debt fund net asset values have been seen swinging down. If you have not carefully selected your debt fund investments, chances are you will miss the opportunity to get better yields.
The good news: RBI has raised interest rates and has increased the repo rate by 25 basis points to 6.5 percent. All debt products, including fixed deposits, will now fetch a better yield to debt investors.
This will raise invetor interest in the debt market.
Yet, remember not all debt funds are suitable investments in this rising interest rate environment. Debt fund net asset values fluctuate according to the interest rate movment in the economy. This puts certain categories of debt funds at a disadvantage to the rest.
HOW DEBT FUND NAVS MOVE
So how does the debt funds net asset value fluctuate? The holdings in a debt fund are marked-to-market, which means they are repriced every day. So if the debt paper price falls, the NAV of the fund also tends to fall. In other words, debt funds also fall and rise in value.
Of course, price movements in debt paper are usually not as high as equity barring for a few days when there is a sharp movement in interest rate in the economy.
But know one fact: If interest rates rise, net asset value of debt funds fall as the underlying fixed income paper falls in value. With the interest rate hike, debt paper has been repriced downwards. This has improved the yields of older debt paper.
In such an environment, short-term debt mutual funds, or liquid fund, or ultra-short term debt funds are the better-suited funds for investment.
One of the factors that will drive debt fund NAV is the future interest rate movements. For now, interest rates are likely to remain firm and the markets expect one or two more rate hikes.
A fallout of this is that long-term debt funds are impacted negatively when rates rise. In fact, investors have to keep in mind the duration or the average tenure of the holdings of a debt fund. The longer the duration, the higher will be the volatility in a bond fund and reaction to interest rate movements.
Over the past year, due to rate increases, long-term debt funds have yielded very low returns of less than 1-2 percent.
Short-term debt funds, on the other hand, have held steady at 6-7 percent returns. In the coming quarters, chances are that short-term debt funds could remain in flavor.
WHY SHORT-TERM DEBT MUTUAL FUNDS
Short-term debt mutual funds, on the other hand, are essentially funds that invest in corporate bonds, corporate debt, government securities that are expected to mature in 1-3 years. Liquid funds and ultra-short-term funds invest in debt paper that matures in 3 months to less than a year.
These are papers that don’t swing a lot to interest rate movements, unlike a longer-term debt paper of, say, over 5-10 years. In short, the higher the duration the more the volatility.
With a lower volatility and a better yield in debt funds, investors seeking debt funds now should look at the short-term debt funds.
Maintain a conservative approach to debt funds and don’t pull out when interest rates are increased again. If you are investing in debt funds now, make sure you invest for the entire duration of the fund such as over a year. This way you will lower volatility and raise the odds of you earning a better return.
