What debt funds are good in a low-interest rate regime?

The interest rates in the country are at a low and bank deposit rates are not that great. So, investors could look at debt funds for higher returns.

Kavya Balaji   /   November 20, 2020
What debt funds are good in a low-interest rate regime

The Reserve Bank of India (RBI) has been cutting interest rates for the last few years. Since then yields of fixed income securities have been falling. The yields of government bonds have been steadily declining for the past two years. Yields were more than 8.1% in 2018 and are now below 6%.

If you look at the reverse repo rate (the rate at which RBI borrows money from commercial banks), it is at a historical low of 3.35%. The difference between the repo rate and the 10-year government bond yield is at a historical high. Usually, the difference is 50-100 basis points. Now, it is more than 250 bps. The higher difference means lower interest rates are not properly transmitted to borrowers and cheap credit isn’t available for the citizens.

While borrowers aren’t enjoying higher rates, depositors have to take the lower rates offered for their savings accounts and deposits. Given the scenario, investors could look at debt funds for higher returns. The historically high spread between government securities and the reverse repo rate provides attractive opportunities to debt fund investors over the medium term. The difference between government securities and corporate bonds also provide an opportunity to investors to make profits on their investments in the medium term.

Which debt funds are good now?

Fund managers are now allocating money to the longer end of the yield curve as interest rates are remaining low. Funds such as medium duration funds, credit risk funds and dynamic bond funds look poised for good returns if investors stay invested for three to four years. These are funds that can take advantage of the arbitrage opportunities available in the debt market. Even some short duration funds could be considered by investors with a low risk appetite.

Short duration funds usually have durations between 1-3 years. So, short duration funds can invest in short term and slightly longer-term debt securities. Short duration funds have lower interest rate risk when compared to medium and long duration funds. They invest in government securities such as treasury bills, derivatives, Public Sector Unit (PSU) bonds and rated corporate bonds. Data from AMFI shows that short duration funds have been sought after by investors recently. More than 41,000 folios have been added in a month in these funds.

Medium duration funds are open ended debt mutual funds that invest in securities with maturity of about 3-4 years. The fund manager invests across securities with different credit qualities. So, the credit risk is higher. However, since interest rates seem to be on a downward trend and won’t be moving up anytime soon, the interest rate risks for these funds are much lower than that of long duration funds.

Credit-risk funds are funds that invest approx. 65% of their assets in less than AA-rated securities. By taking greater credit risk, they provide high returns. The interest rate risk for these funds is low because most of them are of a lower duration. Typically, these funds can provide 2-3 percent more returns than risk-free investments. Since timing of entry and exit in credit risk funds is not advisable, these funds should be avoided by novice investors or investors with a low risk appetite.

How have these funds done?

Short term funds with duration of 2-3 years such as corporate bond funds and banking PSU funds have done well in the last few years. They have provided investors with annualised returns of over 7.5% and 8.5% in the last 3 years. This is much higher than the interest rates given by bank deposits and tax-free bonds. So, investors with a low to medium risk appetite could look at short duration funds and banking, PSU funds while those with higher risk appetite can consider medium duration and dynamic bond funds.

It is very important for you to assess your risk profile before investing. For instance, dynamic bond funds carry higher duration risks while credit risk funds have higher credit risks. One should allocate based on their risk appetite and time horizon available for the investment. Also you should be aware of the risks being taken by the fund manager in each debt fund.

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