Are short-duration funds a good bet as interest rates rise?

Debt-oriented mutual funds witnessed a net outflow of 32,722 crore in May compared with the previous month’s net inflow of 54,756 crore, data with the Association of Mutual Funds in India (Amfi) showed. 

This is likely to be fallout of the Reserve Bank of India (RBI) hiking the policy repo rate by a cumulative 90 basis points (bps) to 4.9% during the span of a month.  One basis point is one-hundredth of a percentage point.

As per Amfi data, in the open-ended debt category, only overnight and liquid funds saw net inflows to the tune of 1,6847.77 crore. On the other hand, money market funds saw a significant outflow of 14,598 crore in this category, followed by short duration funds at 8,603.03 crore and ultra-short duration funds at 7,104.96 crore. 

This move could be a sign of investors‘ short-term money requirements due to the current market scenario of rising repo rates and inflation rates, said Priti Rathi Gupta, founder, LXME. 

Pankaj Pathak, fund manager, Fixed Income, Quantum AMC, said  liquid and overnight funds have large portion of their assets under management (AUM) from institutional investors such as banks and corporates. “Typically, these investors redeem at the quarter end and reinvest in subsequent months. You can see this trend in the last three months as well. In March, there were large outflows from these categories and during April and May these investors came back. This is  normal in the liquid and overnight category,” said Pathak. 

According to a recent report by Axis Asset Management Co. Ltd, for investors, the sharp rise in yields means that markets have already priced in the worst of the rate movements. 

“We believe the markets have priced overnight rates rising to 6%+ over the medium term. With current repo rates at 4.90% this implies more than 100 bps of incremental rate hikes factored into bond yields,” the report stated. 

RBI has hiked the policy repo rate by 90 basis points. The three-year bond yield has moved up by over 170 basis points since the start of this year. 

“We have seen this trend in past – bond yields moved up sharply till the first rate hike and then become range bound or move up only gradually. Our sense is that bond yields will be less sensitive to RBI’s rate hikes going forward. Keeping this in mind, 7% plus accrual yield on 3-year government bonds do look attractive,” said Pathak. 

 According to Axis MF, for investors with medium term investment horizon (above three  years), incremental allocations to such duration may offer significant risk reward opportunities. For investors with short term investment horizons (six months-2 years) floating rate strategies continue to remain attractive as interest rate resets and premiums offer competitive ‘carry’ and low volatility. Credits can also be considered as ideal ‘carry’ solutions in the current environment. The carry return is the coupon on the bonds minus the interest costs of the short-term borrowing.

Quantum AMC’s Pathak suggests, “Within debt mutual fund, category and scheme selection should be based on one’s investment horizon and risk appetite. Investors with low risk appetite and shorter holding period should stick to categories like liquid fund or other low duration funds. However, investors with atleast 2-3 year time horizon can move their allocation to short term bond funds or dynamic bond funds in a staggered manner.”

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