Prime Strategy: How to invest in debt funds now?

Please note that debt fund taxation has undergone a change. Indexation benefit will not be available for investments made from April 1, 2023 onwards. You can read about this in our article, ‘Tax changes in mutual funds: How to manage your investments now‘.

If you had invested in an ultra-short debt fund like Axis Treasury Advantage 3 years ago, your returns would be 7.3% CAGR now. Not bad at all by today’s standards, right? If you invested in the same fund 2 years ago in November 2019, your returns would be 6% – still not terrible. But what if you had invested in this fund just a year ago? 

Your returns would be 4.2% now! And worse, if the sideways interest rate scenario continues, your returns might not improve even if you held it for 2 years! So, the question is – how should you invest in debt funds in the present interest rate scenario?

Where are we?

The last repo rate cut by RBI was in May 2020 (see table below) and the last time the 10-year government bond yield (G-Sec) was over 7% was in June 2019. Despite a spike in inflation, up to June 2021, the RBI’s G-SAP programme along with control over fresh government bond issuance rates kept the 10-year G-Sec range-bound – at under 6.5% since the last rate cut. In other words, rates haven’t moved anywhere – up or down – for almost 2 years now.

Before we move to what a flat rate means, let us first briefly (not considering the impact of various extraneous factors) understand how mutual funds react to rate cuts and rate hikes. 

• When a rate cut happens, prices of existing bonds move up to adjust to the new lower rates (as the higher prices reduce yields). This price rally is most pronounced in longer duration (gilt, constant maturity etc.), moderate in medium duration (corporate bond, banking & PSU short duration) and marginal in lower duration (money market or ultra-short term etc.). So, in a falling rate scenario, your medium to long duration funds gain well due to what we call the price rally or ‘capital appreciation’. 
• When rates hit the bottom and start moving up (say, triggered by local inflation or global liquidity tightening), then ultra-short and shorter duration bonds gain quickly from the new higher yields on newer bonds they add (since they can quickly redeploy in higher interest securities). Medium duration also starts earning high accrual (and eventually exceeds short duration return) but does so with a lag. As a result, this category would see some fall from the rising yields initially but as fresh money is deployed in higher-returning bonds, accrual income (income from interest) starts kicking in. Longer duration bonds though suffer the most. As rates rise, prices of their existing holdings start falling, generating loss for a while and then settle to some accrual (remember g-sec income will be lower than corporate bond income). 

So far, so good. But what happens when rates stagnate, as they are now? Shorter duration funds cannot gain from rising rates. Nor can longer duration gain from any falling rate. So - returns stagnate across the board! This is what we’re seeing now. Your returns are what they are in the past 1 year, in the 3-5% range!

Why it’s different this time

In fact, if we take categories such as money market or ultra-short, we are currently facing the worst 1-year returns in the past 10 years! This is true of most shorter duration funds as well. In other words, short term debt funds simply failed to deliver. 

For corporate bond and gilt categories, it’s slightly better. Their 1-year returns in 2018 were worse (considering rolling returns over a 10-year period) than now. So, it’s not the worst period for this segment. Besides, their 2-year returns are holding up quite well at around 7.7% on an average, even now.

But what is different this time is the prolonged sideways movement of yields. Look at the 10-year g-sec yield movement in the past 20 years in the graph below. Every time a low was hit, there was a relatively quick bounce back, triggered by rate hikes locally or due to global events. This time around, for almost 2 years, we have seen no meaningful up move, even as the macro-economic situation warranted it. That the government has kept rates steady for various reasons is a separate discussion. 

Bottom line - we are seeing an unusual period of stagnant rates and that is not good for your fund returns.

Will yields move up?

Will this stagnant rate situation change? It may, if recent trends finally force their way into play. Even if the RBI responds less to local inflationary issues (under control now), the recent US inflation numbers at 6.2%, announced on Wednesday, has given a rude shock to global and local markets. 

While short-term treasury yields in the US spiked, locally too, the 10-year G-Sec moved up 0.65% (as we write this). If this high inflation bothers the US Fed, then a rising yield globally and locally can happen. But it is quite early days to conclude that this will happen. 

Even without the Fed action, what we are seeing is a marginal uptick in yields compared with a year ago in shorter duration commercial papers, certificate of deposits (CDs) and treasury bills (see data below), triggered by news about high inflation expectations in the US. If this slow upward continues to be driven by persisting worries on US inflation (which has been pushed up by supply chain constraints and prices of gasoline), we could see yield rise further. But this may pan out only if the US inflation is not a temporary phenomenon and if our government does not ‘manage’ local yields too much.

If it does not – well, it’s more or less status quo until the RBI either reduces its managing of yields or market forces are firm enough to drive yields higher across the board.

Where to invest?

Given this will-it-or-won’t-it scenario, if you had to invest fresh money now, where should your money go? For this purpose, it is best that you take a time frame-based approach to investing than looking at where returns are best. So, we’re splitting strategies into very short-term money and short-term money, medium term money and long-term money.

#1 Very short duration

For those of you using liquid funds to just park money temporarily (and not for STP), you may be better off investing in savings accounts of banks that provide you slightly higher rates or short-term fixed deposits. You can use our FD tool to see if the banks you choose have a ‘high confidence’ rating from us. 

For those looking at 3 months to 1 year, your ideal choice in mutual funds would be ultra-short funds. However, with some banks offering savings and deposit rates up to even 7%, the returns will work out better than liquid funds, even if rates were to rise in the medium term. You can use a mix of regular banks and small finance banks. You will find our fixed deposit recommendations here, if you need help in identifying options. 

You will have time to enter ultra-short funds when rates start rising visibly. If you choose new-age banks or small finance banks, ensure that your risk is capped to Rs 5 lakh (limit of insurance from DICGC) per bank. Avoid being tempted into going for longer-time frame FDs if the rates look higher than the short-term ones, as you will be locking yourself out of potential better rates if yields move up.

#2 Short duration

For money that you would typically park for 1-2 years, we would suggest a 3-pronged strategy. 

• One, you could allocate 40-50% of your money to FDs (as mentioned above) of up to 1 year, if you are game for investing in slightly higher earning FDs. You can also check our FD recommendations for deposits for this time frame.  Also, do read our article on our changed FD strategy and why you will now have more FD options with relatively attractive rates to invest in
• Two, you can continue to invest about 30-40% in floating rate funds, short duration and banking & PSU debt funds. Don’t expect them to deliver anywhere near your FDs and be aware that they can be volatile over a 1-year period. But these funds can make up for such dips when rates start rising, besides allowing you to capture any rise in yields which you will lose out on in FDs. Check Prime Funds for our recommendations. 
• Three, if you can handle a few months of negative returns, then about 20% allocation to equity savings funds might offer you decent returns with low downside, provide support to overall portfolio returns and importantly, give lower taxation. Please do not expect the current high1-year returns in this category to be the norm. These are abnormal times. Expect high single digit numbers, marginally higher than FD from this category – the taxation here makes the difference. You can check our recommendation in this space in Prime Funds.

#3 Medium & long duration

If you follow our Prime Portfolios, you will notice that for time frames less than 5 years, we always mix short and medium duration funds. This is to ensure that the portfolio is not caught off-guard in an unexpected turn in rate cycle. You could follow this approach for your portfolio for over 2-year time frames. Please note that the returns of such funds have not been bad if you take the past 2 or 3 years.

The above data is point to point. The average returns, if rolled daily, are even better. For example, 2-year average rolling return for corporate bond funds was 9% if returns were rolled daily between 2019-21. But do note that these returns were delivered in a period of falling rate scenarios. If you start investing in long duration funds in a period of climbing rate, know that your returns will be low over the short to medium term. This is where mixing durations helps. Therefore, for periods between 2-5 years follow a strategy of mixing floating rate/short duration and medium duration funds. 

For a time frame of over 5 years too, you can follow the same strategy. You could also hold only medium and long duration funds (such as constant maturity or gilt), as you have the time to allow yields to rise and fall improving returns. SIPs can provide some comfort in this period as there is bound to be some volatility. 

Avoid locking into FDs for longer timeframes such as 5 years now. You can consider FD options when rates go up, especially if you are in the low tax bracket. Also, remember, the capital gains indexation comes to your rescue in mutual funds for holdings over 3 years, compared with FDs.

Other possibilities

Income seekers: One category of investors who are hit the most in this rate scenario are the income-seekers, whether senior citizens or not. For them, over-drawing from their corpus (higher rate of SWP) may result in corpus depletion in this period. In those cases, apart from FDs of about 1 year, we would recommend going with RBI’s Floating Rate Savings Bonds for a part of the corpus to ensure superior income, safety and automatic reset of rates when they go up. If you have a larger corpus or are in a higher tax bracket, small exposure (15-20%) in equity savings funds and using them for withdrawal after 1-2 years of holding is also an option. 

Your existing investments: Unless you are looking for some income from your portfolio and as long as you have invested based on your time frame, you should allow your funds to go through the rate cycles. More so, if they are part of your long-term asset allocated portfolio. The above strategy holds good only to diversify your portfolio to other fixed income options, given the prolonged stagnant rates.

When there are signs of rates moving up, we will come up with a call on categories of mutual funds you can benefit the most from. Until such time, you need not feel constrained to hold only mutual funds. You could consider other FD options that are now less risky, post the DICGC rule changes, if you’re very keen on finding better-returning avenues. But make sure you stay clear of high-risk options such as the one we covered here.