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How investors in debt MFs can navigate a rising yield scenario


Fund managers don’t expect this trend to continue and there is a distinct possibility that it may reverse, according to some of them. Here, we look at the strategies that investment professionals are adopting in response to an environment of rising bond yields.

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Normalizing liquidity, pause on rate cuts and govt borrowing are likely to make long-duration debt funds unattractive

In a forthcoming interview in Mint, Rajeev Radhakrishnan, CIO of fixed income at SBI Mutual Fund, notes that the RBI may need to normalize liquidity over the coming months gradually, aligning money market rates upwards. This is likely to improve the yields in categories such as liquid funds, which have delivered around 3.5% over the past year.

However, a combination of normalizing liquidity, pause on rate cuts and higher-than-expected government borrowing are also likely to make long-duration debt funds unattractive.

“We may not see a reversal of rates anytime soon, but it’s very clear the RBI is done with rate cuts,” said Radhakrishnan.

In this situation, the environment has gotten tougher for debt fund investors. Experts have adopted a range of strategies to deal with the situation.

Shorten duration to lower risk: “In this environment, the three to four-year duration bucket doesn’t offer much opportunity. We are advising clients to stick to the very short end or go for arbitrage funds,” said Prateek Pant, co-founder and head – products and solutions at Sanctum Wealth Management.

High-duration funds are more sensitive to interest rate movements and this sensitivity is measured by a metric called ‘modified duration’. Over the past month, categories with high duration such as gilt funds and dynamic bond funds have suffered the strongest impact, while liquid and money market funds have suffered almost no impact. On the flip side, however, the yields on liquid funds are extremely low to begin with, pushing intermediaries to recommend alternatives to mutual funds altogether.

“For very short-term needs, I am suggesting high-interest savings bank accounts such as Equitas Small Finance Bank. It is giving an interest rate of 7% and money up to 5 lakh is protected by the Deposit Insurance Programme,” said Anant Ladha, an MF distributor based in Kota, Rajasthan.

Alignment with time horizon: Investment advisers have asked investors to focus on their own time horizons and align it with the choice of debt fund.

Vishal Dhawan, founder, Plan Ahead Wealth Advisors, a Sebi-registered investment adviser, said, “Mark to market effects are immediate while coupon payments accrue over a period of time. So, don’t look at returns over the last one-three months and extrapolate. Continue to align the debt categories you select with your time horizon. For example, low-duration funds for less than one year or corporate bond funds for one-three years.” However, he added a cautionary note, stating, “We don’t normally recommend more than 20-25% of debt allocation being in long-duration, gilt or dynamic bond funds.”

Selective exposure to credit risk: The credit risk category fell out of favour after the IL&FS crisis starting September 2018. Its downfall accelerated with the shock freeze on six Franklin Templeton mutual funds in April 2020. The size of the category dropped from 79,643 crore at the end of April 2019 to 28,482 crore at the end of December 2020. However, January 2021 saw a positive inflow into the category of 366 crore after a long gap.

Fund houses have also begun inching back into credit risk, as the shock of the Franklin Templeton Mutual Fund episode fades from public memory.

IDFC Mutual Fund recently launched a ‘floating rate fund’ with the USP of a ‘credit-lite’ strategy with low duration. The fund is slated to take an exposure of up to 30% of its corpus in high-yielding paper with the stipulation that there will be no investment in paper below AA- at the point of investment.

Mutual fund distributors are also selectively recommending credit risk funds, particularly those that survived the covid-19 shock in April-May 2020 without serious losses.

“I’m selectively suggesting credit risk funds such as the one by ICICI Prudential MF, where I have enough comfort on the management quality,” said Ladha.

Pant also asked investors to take some exposure to credit risk.

A sprinkling of equity: PPFAS Mutual Fund recently filed with Sebi for a conservative hybrid fund, which it essentially views as a debt fund. A conservative hybrid fund invests 10-25% of its assets in equity.

“We want to replicate the idea behind Parag Parikh Flexicap on the debt side. This stems from conversations we have had with investors. This will be a go-anywhere debt fund with a sliver of equity exposure from 10% to 25%. It will not be boxed into any particular type of debt like short term, government bond or high yield,” Neil Parikh, CEO, PPFAS Mutual Fund told Mint on 4 February.

SBI Mutual Fund has pushed down the expense ratio on its conservative hybrid fund to attract new investors.

“The expense ratio on SBI Conservative Hybrid Fund is currently 0.4% on the direct plan and 1.1% on the regular plan. We believe that in today’s low-yield environment, this category is strongly positioned to deliver value to investors at relatively low risk,” said D.P. Singh, chief marketing officer, SBI Mutual Fund.

Investors should note that equity carries a much higher level of risk than debt. However, industry executives see it pushing up returns in a category saddled with low yields.

Investors should carefully consider their time horizon and risk appetite before adopting any of the strategies described above.

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