Short-duration funds suit conservative investors during pause in rate cycle

Take a tactical bet on longer-duration funds when RBI moves to a tightening stance

With the Reserve Bank of India (RBI) having hiked interest rates by 225 basis points since May this year, bond yields have moved up. The benchmark 10-year bond yield is currently at 7.29 per cent, from 6.37 per cent a year earlier.

Fund managers are of the view that there may be one more rate hike in the current cycle. “With the peak of inflation now behind us, and the projection of consumer price index (CPI)-based inflation reaching within the RBI’s comfort band by Q1FY2024, we believe the rate hike cycle is almost near its peak. The Monetary Policy Committee (MPC) is likely to go for another rate hike of 25 basis points (bps) in February 2023 policy and then take a pause,” says Anand Nevatia, fund manager, Trust Mutual Fund.

One category of debt mutual funds that conservative investors in particular should opt for is short-duration funds. According to the Securities and Exchange Board of India’s (Sebi) definition, these funds invest in debt and money market instruments having duration between one and three years.

Well-suited for flat curve

After the RBI has hiked the repo rate by another 25 basis points, it is expected to pause. At present, the RBI’s stance is one of withdrawal of accommodation. When it pauses, it would shift to a neutral stance. It would then allow the economy (which would be in its mid-cycle) to expand. The pause could possibly be a long one. Investors need to create a portfolio that is suited for this pause.

“Short-duration funds invest in securities having a maturity of one-three years. These funds are relatively less volatile,” says Abhishek Dev, co-founder and chief executive officer (CEO), Epsilon Money Mart.

Currently, most of the returns are likely to come from portfolio yield. Says Nevatia: “Short-duration funds benefit from both accrual and interest rate play in the debt market. Their design ensures investors are never subjected to extra risk and volatility through exposure to very long-duration bonds. Barring a small period when rates fall rapidly, they tend to either outperform or are on a par with other open-ended debt schemes.”

Enter longer-duration funds?

After the mid-cycle phase of expansion, the economy will enter the late stage of its cycle. This is characterised by excess demand or capital allocation problems. That is when the central bank will move to a tightening stance. It will then increase the repo rate to slow down the economy. The ideal time to take a tactical bet on longer-duration funds (which have a portfolio with average duration above seven years) is when the RBI moves to a tightening stance. Because as the economy begins to slow down due to its tightening stance, the central bank begins to cut rates.  

Moreover, the yield curve is flat at present. The yield on longer-duration bonds is not very attractive compared to short- and medium-duration bonds. Investors are not getting sufficient carry to compensate them for the additional duration risk they would take by entering longer-duration bonds (or funds).

Some experts, however, believe this is a good time to enter longer-duration funds. Says Vikram Dalal, managing director, Synergee Capital Services: “At present short-duration funds will give a return of 6.5-7 per cent pre-tax. The interest rate cycle is expected to reverse in another 6-12 months. Longer-duration funds will give better appreciation in comparison to short-duration bond funds.” He suggests investing in these funds in a staggered manner.

What should you do?

Investors should ideally match their investment tenure with the duration of the fund. Conservative investors with a three-year or slightly higher horizon should invest in a short-duration fund.

Says Dev: “Investors who want to take indexation benefit should hold these for over three years.” Gains from debt fund units sold after three years are treated as long-term capital gains and are entitled to a more favourable tax treatment: 20 per cent with indexation.  

Investors who have a long horizon—say, seven years or more—may invest in a longer-duration fund.