Align investment horizon with portfolio duration for short-term debt funds

Shorter-duration debt funds received the bulk of inflows into debt mutual funds in November 2024. Overnight funds (Rs 2,019 crore), ultrashort duration funds (Rs 2,962 crore), low duration funds (Rs 4,374 crore), and money market funds (Rs 2,426 crore) were the main beneficiaries.

  High liquidity led to inflows

  Currently, most of the money flowing into debt funds is from institutional investors. “They use debt funds to park their short-term surpluses,” says Mahendra Jajoo, chief investment officer, fixed income, Mirae Asset Investment Managers.

  According to Joydeep Sen, corporate trainer (debt markets) and author, corporates prefer the shorter end of the curve because the longer end can be volatile.

 

  The short end of the curve is linked to market liquidity. “In the past couple of months, the government has spent massively, which improved banking liquidity. The Reserve Bank of India (RBI) maintained easy liquidity in the banking system from July onwards. 

  The absolute quantum of liquidity in the banking system was higher in July, August, September, and October, which led to flows,” says Devang Shah, head of fixed income, Axis Mutual Fund.

  Once the RBI changed its stance in the October policy, the market started expecting some easing on the liquidity front. “The RBI delivered in the Dece­mber policy by cutting the cash reserve ratio (CRR) by 50 basis points,” says Shah. Both these factors led to higher flows into shorter-duration debt funds.

  More stable funds

  Shorter-duration debt funds are less volatile. “Interest rates are expected to come down, but it may not happen. Donald Trump’s trade policies could lead to higher inflation in the United States, which could then have a cascading impact on the rest of the world, including India,” says Jajoo. Sen says investors in shorter-duration funds will be impacted less from losses if interest rates rise.

  The yield curve is flat at present. “If investors go for longer-duration bonds or bond funds, the uptick in accrual is minimal. They are not getting adequate compensation for taking extra risk, which is why many are preferring shorter-duration funds,” says Sen. 

The RBI has changed its stance and cut the CRR. Next, it could begin rate cuts from its February policy. “For people looking to park money for the short term and benefit from the easy liquidity situation and rate cuts to some extent, shorter-duration funds can be a good solution,” says Shah.

  Tighter liquidity could cause volatility 

Generally, liquidity gets tighter in the January–March quarter. “If banking liquidity gets very tight and the RBI does not infuse more liquidity, we could see some volatility in returns of shorter-duration debt funds,” says Shah.

  If a rate cut rally occurs, these funds would participate to a lesser extent.

  Select the right category

  While all investors should have some allocation to shorter-duration debt funds for portfolio stability, the exact proportion should depend on their risk appetite.

  To select the right category of shorter-duration fund, investors should opt for duration matching. “Your investment horizon should be equal to, or slightly less than, the maturity or duration of the fund,” says Sen.

  To select the right fund, Shah suggests checking a fund’s fact sheet, riskometer, and Potential Risk Class (PRC), which inform investors about its credit quality and duration appetite.

  Compare fund returns with the benchmark and category average. Choose a mid- or large-sized fund house with a proven track record. Sen suggests avoiding very small funds so that redemption pressure does not lead to high volatility in corpus size.