Take the short-term route

As timing of interest rate fall remains uncertain, short-term funds look the best bet

Interest rates have peaked, and may begin their journey downwards anytime now. But, no one knows when. In a situation like this, many are advising getting locked into long-term funds, to get the best possible returns. Between 2009 and 2011, interest rates kept rising. This led to the decline in bond prices, as interest rates and bond prices share an inverse relationship. After having peaked, interest rates are now set to fall, and bond prices rise.

There are signs of the interest rate cycle relenting. In such a scenario, the individual investor needs to act in order to ensure that his debt mutual fund portfolio remains profitable. There are several implications for the portfolio. Hence, decisions will have to be taken in order to gain from the changes that will materialise over the next year or so. Let’s take a closer look at how the investor can grapple with this situation.

First, investors should put money in short-term funds, as opposed to long-term ones, which were being advised till a while back, says Sumeet Vaid of Freedom Financial Planner. Reason: Interest rates are likely to fall, but no one knows when and by how much. Given the uncertainty, short-term funds are the best bet. Also, the impact of the rise in interest rates is lesser on short-term funds. Short-term funds, experts say, are more likely to give steady returns when the market isn't doing well, and at 10-11 per cent, they look very attractive.

According to mutual fund rating agency Value Research, as on March 14, short-term funds have returned 9.29 per cent in the last one year. In the same period, ultra-short term funds returned 9.19 per cent, income funds 8.96 per cent and liquid funds 8.93 per cent. But, remember, you may not get returns on your investment that easily, as interest rates may fall unevenly. So, for a while, you may just see your investments going nowhere.

However, as the situation unfolds, short-term funds could underperform. "Once the rate cuts begin and there is certainty on their timing, you should invest in long- and medium-term funds. Funds investing in long-term papers see a sharp rise in their value and, hence, give better returns (when interest rates start declining)," Vaid explains.

So, those looking to invest in debt funds should opt for the short-term route (for six to 12 months) in funds that have a horizon of 1.5 to three years, advises Mahendra Jajoo, chief investment officer (fixed income), Pramerica Asset Managers.

However, the Reserve Bank of India's (RBI) capital injection hasn't quite stabilised the debt fund market (March typically sees a tight monetary situation). In the last six months, the apex bank injected Rs 2 lakh crore into the banking system, by lowering the cash reserve ratio (CRR) and through open market operations (OMOs). "The money multiplier effect (money deployed to create more money, calculated by dividing the total bank deposits by the cash reserve requirement) will be visible from next month, when yields start falling," says Lakshmi Iyer, head, fixed income and product, Kotak Mutual Fund.

In the absence of such action by the RBI, the short-term rates would have gone up even higher. For instance, a month back, these stood at 9.5 per cent, before moving to 11.5 per cent last week. The rates climbed down a little to 11-11.25 per cent last Thursday. Similarly, long-term rates fell from nine per cent to 8.25 per cent. "A CRR cut would help short-term rates stabilise and bond purchases will see the long-term rates come off their peak," adds Jajoo.

For those already invested in short-term funds, Iyer suggests to stay put for another six months, as March is not the time to exit on mark-to-market losses. The rates, usually, are very volatile at this time of the year. "The outlook is positive, as rates are near their peak and will take time to come down drastically," she says.