Don't want volatility in debt portfolio? Stick to shorter-duration funds

If you have a three-five-year horizon, you may invest in corporate bond funds and banking and PSU funds.

With the Reserve Bank of India (RBI) kicking off the rate-hike cycle in May, and more hikes expected, the one-month average return for most categories of debt funds has tipped into the negative. Many investors are choosing to flee debt funds. According to data from the Association of Mutual Funds in India (Amfi), short duration (Rs 28,483 crore), medium duration (Rs 3,973 crore), corporate bond (Rs 25,674 crore) and banking and PSU debt funds (Rs 17,285 crore) have seen considerable amount of redemption between January 1, 2022 and April 30, 2022.

Volatile times ahead

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With inflationary pressures mounting, central banks around the world have started hiking interest rates. Rising rates are detrimental to debt fund returns as mark-to-market losses eat into portfolio accruals. “Inflation is rising rapidly, forcing the RBI to raise rates and reduce liquidity. The repo rate could go up to 5.5-6 per cent within the next one year. Bond prices are falling, leading to a decline in the net asset values (NAVs) of debt funds. That is in turn causing investors to withdraw money from debt funds,” says Sandeep Bagla, chief executive officer (CEO) at Trust Mutual Fund.

The upward trend in loterm yields indicates tough times ahead for debt fund investors. “The off-cycle hike in the repo rate caused the yield on the benchmark 10-year government security (G-Sec) to move above the 7 per cent level. Rates are expected to rise further in the near future,” says Vikram Dalal, managing director at Synergee Capital Services.

Girirajan Murugan, CEO, FundsIndia agrees. “With bond yields expected to move up further over the next 6-12 months, investors should be prepared for higher volatility in their debt fund portfolios over this period. The extent of volatility will depend on the modified duration of the fund: Higher the modified duration, greater the volatility,” he says.

Choose category based on horizon

With the returns on medium and longer-duration debt funds turning negative, worried investors are pressing the sell button. However, if you have an investment horizon that matches the average portfolio duration of these funds, then it is better to stay invested. Only those who have realised they don’t want high volatility in their debt portfolios should exit.

Such investors should stick to shorter-duration funds. “Investors uncomfortable with near-term volatility in their debt fund portfolios should stick to lower-duration segments (those with modified duration of less than one year) such as liquid, ultrashort duration, low duration, and money market funds. Those with a horizon of three-five years and willing to tolerate volatility over the next 6-12 months may increase their exposure to segments such as short-duration funds, corporate bond funds, and banking and PSU funds,” says Murugan. He adds that high-quality target maturity funds with duration of four-five years also look attractive at the current juncture.

According to Bagla, “Roll down funds with up to two years’ maturity, banking and PSU funds, and shorter-duration funds should perform well.”

Maintain asset allocation

Exposure to fixed income brings stability to portfolios. Also, if you have short- or medium-term goals, and want to enjoy liquidity, then you need to allocate money to debt funds. Such money can’t be allocated to stocks and equity funds. “Investing in bond funds will also protect your capital and provide passive income over time,” says Dalal.

With debt funds expected to experience volatility, investors should try to stick to their asset allocation. “Continue with your original asset allocation mix between equity and debt. If there is a deviation of more than 5 per cent from the original asset allocation, rebalance and return to your original asset allocation mix,” says Murugan.

Finally, try to match your investment horizon with the duration of the product. For example, if you are keen to invest for three years, invest in a short-duration fund, which maintains a portfolio duration of one to three years.