The net asset values (NAVs) of debt funds have fallen sharply due to the rise in bond yields after the announcement of massive government borrowing in the budget. Long-tenure funds have fallen the most. Gilt and long-duration funds have declined the most. Even less-risky short duration bond funds have lost money. Of the 28 short duration funds, 20 schemes have decreased in value in three months ended March 4, 2021, as per Value Research data.
You can ride out the interest rate volatility if you can stay invested for about 3-4 years. But what if you wish to invest only for a year? Try money market funds and low duration schemes.
How do they work?
As per Securities and Exchange Board of India (SEBI) norms, a low duration fund (LDF) invests in debt and money market securities. The Macaulay duration of the portfolio is kept at 6-12 months. A money market fund (MMF) invests in debt instruments that mature within a year. These funds minimise interest rate risk. Though they appear similar, there are differences.
Maturity versus duration
Your fund manager could invest in overnight securities or those that mature slightly later. Or, she can just choose a mix.
A low-duration fund is slightly different. Its Macaulay duration has to be 6-12 months. In simple words, some instruments can be of a shorter duration (such as those that mature in less than a year) or longer period. The portfolio’s Macaulay duration has to be within the SEBI-prescribed limit.
The longer dated bonds (maturing after one year, in this context) bring in higher interest income and also increased interest rate risk.
SEBI does not specify the credit quality of bonds in which the fund manager can invest.
In the last three months, LDF and MMF have given 0.69 percent and 0.73 percent returns, respectively as a category, as on as per Value Research Data. Over the past three years, these schemes have delivered 5.07 percent and 6.63 percent returns, respectively.
Can they control interest rate risk?
The interest rate risk is limited, as most of these schemes restrict themselves to bonds maturing in short term. Here, a money market fund scores, as it just cannot invest in bonds that mature beyond one year due to SEBI’s regulations. That is because a MMF is defined by the maturity of each of its underlying securities.
A low duration fund is defined by the overall portfolio’s Macaulay duration. Hence, it can invest a part of its corpus in slightly longer-tenure securities to get a returns kicker.
“Conservative investors keen to reduce interest rate risk can consider investments in low duration and money market funds in a rising interest scenario, as these schemes generally invest in bonds maturing in the short term,” says Mahendra Kumar Jajoo, CIO-Fixed Income, Mirae Asset Investment Managers (India).
Joydeep Sen, Corporate Trainer- Debt Markets, concurs, “When the interest rates are rising, investments in bonds maturing in the short term give opportunities to the fund manager to reinvest their maturity proceeds at regular intervals at higher interest rates.”
Jajoo advises assessing the credit quality. As per Value Research data, LDF as a category invests 11.65 percent of the assets in AA-rated bonds.
The presence of longer-term bonds in some LDFs also increase the interest rate risk.
While some MMF schemes use the roll down strategy, some dynamically manage their portfolios. Understanding these aspects will help you set your expectations right. Also, you should keep track of the expense ratio.If you can sit through the interest rate cycle, then you can invest in short duration funds as well.