Are ultra short duration funds better alternatives to low-yielding overnight schemes?

It’s not just your bank fixed deposit (FD) rates that are falling. Liquid and overnight mutual fund schemes have also been giving lower returns of late, thanks to the falling interest rates. These funds are primarily used to our park contingency corpus or as a temporary pass through to initiate systematic transfer plans in equity funds.

The fall in liquid and overnight fund returns is in line with the cut in the policy rates. The RBI cut repo rate by 200 basis points – from six per cent to four per cent over the last one year. RBI has also taken steps to infuse liquidity in the system.

“The cut in policy rates and abundant liquidity in the financial system has led to a crash in short-term interest rates and hence the mutual fund schemes investing at the short end of the yield curve are reaping low returns,” says Ashish Shanker, head investment advisory, Motilal Oswal Private Wealth Management.

The demand for short-term securities have gone up after the credit crisis that has gripped the debt market over the past year-and-a-half, and more so after the Franklin Templeton crisis.

So, should you switch to ultra short-duration funds for parking your emergency corpus?

Chasing higher returns

The answer to the earlier question lies in the amount of risk you can take. Ultra short and low duration bond funds can be considered if you have an appetite for risk.

Ultra short duration fund portfolios typically have a Macaulay duration of 3-6 months. For low duration schemes the period is 6-12 months. Macaulay duration is the weighted average maturity of bonds in a portfolio, factoring in all the cash flows.

Since you may stay invested for longer in such funds, the return expectations are bound to be higher.

Schemes not risk-free

Since liquid and overnight funds invest in securities maturing in 91 days and one day, respectively, interest rate risk is limited. The fund manager’s focus is on liquidity than on the returns. Fund managers are also focused on capital preservation. Besides, with entire portfolios will soon be marked to market, liquid funds’ net asset values reflect the true value of their underlying portfolios. (SEBI extended the deadline to implement this valuation norm till 30 June 2020).

But ultra short and low duration bond funds invest in slightly longer dated securities.  Even though a scheme’s duration is, say, six months, that’s just the average number. It could still have few long-dated securities.

This increases the scheme’s risk profile. “As the duration increases, the interest rate risk also increases,” says Dwijendra Srivastava, chief investment officer-debt, Sundaram Mutual Fund. Plus, if the bond has been issued by a private sector firm, then credit risk also gets added to the scheme.

According to Value Research, ultra short duration funds and low duration funds have given negative weekly returns on seven and 12 occasions in the last one year, on an average. “If you do not want to see negative returns in your debt fund investments at the time of redemption, try to match your holding period with the duration of the portfolio,” says Srivastava.

Should you invest?

Interest rates are not expected to increase in the near term. But that does not mean you should take undue risks, especially with your short-term money. “If you have less than one month investment timeframe, stick to liquid and overnight funds,” says Joydeep Sen, founder of wiseinvestor.in.

For such short time horizons, even a fixed deposit or just a savings bank account may be better if you just don’t want any complications. For such short horizons, returns don’t matter; safety comes first.

But don’t avoid ultra short duration funds altogether. “If you can hold on to your investment for three to six months and digest negative or flat returns for a very short period, consider investing in ultra short duration funds,” says Ashish Shanker. You can also consider them for systematic transfer plans that help you invest your money in equity funds.

Low duration funds can be considered provided you can hold on to your investment for longer periods. Some of these funds also come with exit loads.

Joydeep Sen recommends investing in schemes backed by leading fund houses with a good track record and good quality portfolios. Additionally, we suggest you stick to larger schemes, as such funds are likely to be well-diversified and less concentrated.