Shorter term debt mutual funds in focus as policy normalisation nears

Anticipating an increase in interest rates over the medium term, debt fund managers are advising investors to focus on funds with an average maturity period of around one-three years.

The Reserve Bank of India (RBI) on Friday kept the key policy rates unchanged but signalled a shift towards policy normalisation. 

Categories like, low duration fund, money market funds and short duration funds are best suited in the current environment, says the market participants.

While the monetary policy committee decided to continue with an ‘accommodative’ stance, Sandeep Bagla, CEO of TRUST Asset Management Company (AMC) says that RBI policy is hawkish at the margin.

“RBI has acknowledged the strong growth and negative surprise on the inflation front. One of the MPC members has voted for change in accommodative stance. There is a distinct possibility that yields at the longer end, will inch up towards 6.5 per cent gradually. Investors should invest in bond funds with less than three-year maturity to minimize interest rate risk,” added Bagla.

Typically, the prices of fixed-income securities are dictated by prevailing interest rates. Interest rates and prices are inversely proportional. When interest rates decline, the prices of fixed income securities increase. Similarly, when interest rates are hiked, the prices of fixed income securities come down.

So longer duration debt instruments are more prone to intense volatility during the period of rising interest rates.

In order to absorb additional liquidity in the system, the RBI announced conducting a variable rate reverse repo (VRRR) program due to the higher yield prospects as compared to the fixed rate overnight reverse repo. The RBI has decided to increase the quantum under the VRRR to Rs 4 trillion in a phased manner.

Pankaj Pathak, Fund Manager- Fixed Income, Quantum Mutual Fund says that we may have seen a nascent attempt by the RBI to ‘normalize’ the monetary policy operations.

“Over the next six months, we would expect RBI to reduce the excess liquidity in the banking system. Accordingly, we would expect an increase in the reverse repo rate from 3.35 per cent to 3.75 per cent, and as growth stabilizes, a subtle move away from the accommodative stance and then to a gradual beginning of rate hikes to narrow the gap between short term rates, currently below 4 per cent and current inflation (~ 5.5 per cent),” added Pathak.

In the last one year, few of the debt categories like money market funds, ultra-short term duration, and dynamic bonds have given returns in the range of 4 per cent. While medium duration and credit risk funds have given average returns of 6.17 per cent and 8.13 per cent respectively in the last one year.

While there might be an increase in interest rates, fund managers also believe that investors who are willing to take slight risk can also look at credit risk funds at this point of time.

“Credits remain an attractive play for investors with a 3-5-year investment horizon as an improving economic cycle and liquidity support assuage credit risk concerns especially in higher quality names. While we remain selective in our selection and rigorous in our due diligence, we believe the current environment is conducive to credit exposure,” added R Sivakumar, head of fixed income at Axis MF.