Bet on money market funds for a horizon of 6-12 months: Should you invest?

For longer periods go for corporate bond funds or banking and PSU funds

With interest rates hovering close to their long-term average peak levels, there is an unexpected performer on the block: Money market funds (MMFs). In recent times, these funds have beaten several other popular categories of bond funds, including banking and public sector unit funds (BPSUFs). MMFs (direct plans) have produced a category average return of 6.93 per cent return over the past year, outdoing BPSUFs (6.84 per cent), and performing almost on a par with corporate bond funds (or CBFs, 6.96 per cent). Do MMFs merit investment at this point?

Mark-to-market impact

MMFs invest in bonds and securities that mature within a year. While there is no stipulation regarding the credit quality of instruments, most fund managers opt for high-quality bonds.

Explaining the performance of MMFs over the past year, Sandeep Bagla, chief executive officer (CEO), Trust Mutual Fund, says, “MMFs invest in highly liquid, short-term assets in the less than one-year segment. A year ago, the spread between three-month and one-year papers was around 100 basis points (bps). This has compressed to 50 bps, boosting their performance.”

Other experts also attribute their performance to mark-to-market (MTM) impact. Joydeep Sen, author and corporate trainer (debt), says, “Over the past year, yields have broadly moved up. Yields and bond prices move inversely, so there was an adverse impact. But since MMFs have lower portfolio duration, they suffered less than fund categories with longer duration.”

Pros and cons of MMFs

MMFs are well suited for investors with a shorter horizon. “They are advantageous for an investment horizon of up to one year as they are less volatile,” says Sen.

S Sridharan, founder & CEO, Wallet Wealth adds, “MMFs are liquid in nature. They are also less volatile when interest rates are rising due to their lower duration.”

Their disadvantage, according to Sridharan, is that they may not offer very attractive returns when interest rates decline, again due to their lower portfolio duration.

Should you invest now?

MMFs are currently in a sweet spot, especially for investors with a 9-12-month horizon. They may offer slightly higher returns than bank fixed deposits of up to one-year tenure. “Interest rates are at their long-term average peak. They may not increase more than 25 bps. In such a scenario, one can continue to invest in MMFs for a one-year holding period,” says Sridharan.

Their average yield to maturity (YTM) is 7.22 per cent (direct plans). Even if one accounts for an average expense ratio of 22 bps, many of these schemes can offer better returns over the next year than they did in the past year.

Interest rates may decline in the future. Initially, short-term bond yields are expected to fall if the Reserve Bank of India (RBI) begins to infuse liquidity in the second half of this financial year (FY). In that scenario, MMFs may register some capital gains.

Investors with a two-three-year time frame would be better off in a CBF, BPSUF or a short-duration fund. “CBFs and BPSUFs usually have a higher accrual level than MMFs. Hence, in future, they are expected to outperform MMFs. However, the market is expected to remain range bound for some time,” says Sen.

Who should invest?

Bagla feels anyone looking for a liquid investment option can consider MMFs. “A person who wants to gain from the roll-down strategy and high liquidity should invest in MMFs,” he says. He adds that an investor can put about 30 per cent of his fixed-income portfolio in MMFs.

Sridharan believes anyone who would like to park his money for six months to one year may consider investing in them for returns that surpass those of bank savings accounts.

Choose carefully

Go for a scheme with a large corpus and a relatively low expense ratio. Also, prefer one with a track record over a new entrant. “While investing in an MMF, look at credit quality, portfolio maturity, fund management strategy, fund size, asset management company’s pedigree, and fund performance,” says Sen.

Bagla adds that one should consider portfolio quality, portfolio yield, and past performance while choosing a fund.