Should you stay in a safer debt fund till there is clarity on rate hikes?

Bond yields and prices move inversely. Rising interest rates would adversely impact the returns of bond funds. The NAV of funds is computed at the prices prevailing on that day.

Interest rates have been moving up and they are expected to move up further as the RBI starts hiking rates sometime. Bond yields and prices move inversely. Rising interest rates would adversely impact the returns of bond funds. The NAV of funds is computed at the prices prevailing on that day. Fixed income investors have been waiting in some ‘conservative fund’ to overcome this problem. Conservative approach here means investing in a defensive scheme. For example, investors in a liquid fund as against a conventional bond fund. This approach is correct; rather than taking the hit on returns, it is better to wait out the volatile time period in a fund with a lower portfolio maturity, with negligible / low volatility.

However, for a comprehensive understanding, another aspect has to be kept in mind. In debt, there are defined fund categories with defined boundaries on what the fund can do. For each of these funds, there is an ideal minimum investment horizon. As long as you can stay put for that much time, you would earn decent returns, in spite of interest rates moving up for some time. There is an accrual in all debt funds, which is the interest on the instruments in the portfolio. As long as interest rates are moving up, a part of the accrual is being taken away by adverse market movement. However, at the end of it, accrual level also moves up, which is good for the fund. An illustration will clarify the concept.

Let us say there is a liquid fund with a portfolio accrual level of 3.5% per year. Portfolio maturity is very low, and we take the impact of interest rates moving up as nil, for the sake of simple calculations. And there is one conventional debt fund, with portfolio accrual of 6% per year, portfolio maturity 4.5 years and portfolio modified duration of 3 years, which measures the sensitivity to interest rate movements. As an illustration of the concept of waiting out, let us say interest rates will move up over the next 6 months by 50 basis points or 0.5% (no one knows it, we are just assuming) and do not move up thereafter. Your horizon of investment is 1 year. For the first 6 months, you wait out in the liquid fund with no mark-to-market impact. Thereafter, you shift to the bond fund. The other option, for the sake of comparison and understanding of the concept, is to invest in the bond fund straightaway, even at the cost of adverse mark-to-market impact.

Now, let us look at the return scenario over the next one year. In the first option, in the liquid funD, for the first 6 months you get an accrual of 3.5/2 = 1.75, per Rs 100 of initial investment. Meanwhile, since interest rates have moved up by 50 basis points in 6 months, the accrual level of the bond fund has moved up from 6% to 6.5%. Over the next 6 months, your accrual is 6.5/2 = 3.25 per Rs 100. Over 1 year, you earn Rs 1.75 + Rs 3.25 = Rs 5 per Rs 100. The other option is to invest in the bond fund straightaway. Over the first 6 months, the accrual is 6/2 = 3, but there is an adverse mark-to-market impact. The modified duration, which is called the multiplier as it measures the sensitivity, is 3. The impact is 0.5% X 3 = 1.5 per Rs 100. Hence the effective return for first 6 months is 3 minus 1.5 = 1.5 per Rs 100. Over the next 6 months, accrual is 6.5/2 = 3.25. Overall return for 1 year in option 2 is 1.5 + 3.25 = 4.75.

This calculation is a very simplistic one, just to illustrate the concept, whereas the real world is more complex. This is without taking into account the tax implications of shifting from one fund to another. The point is, we think more intuitively than mathematically. In the option of waiting out, return over 1 year is 5 per 100 whereas in the second one, it is 4.75. Lower, but only so much.

The recommended holding period for a fund with a portfolio maturity of 4.5 years is at least 3 to 4 years. If you hold this fund even for 3 years, you will earn 4.75 + 6.5 + 6.5 = 5.9% annualized, assuming no further mark-to-market gain / loss. Not bad, against the initial accrual level of 6%. Holding period is relevant, fluctuations will be taken care of.


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