The recent rise in domestic and global bond yields has spooked investors of debt funds – an increase in yields leads to a fall in the value of traded bonds, thereby denting fund returns. However, as with any other asset class, debt instruments have their ups and downs; they closely track the interest rate movement. Interest rates have a significant impact on debt funds based on their yield to maturity (YTM). For instance, long-duration debt funds with higher YTM perform well when interest rates fall, whereas funds that follow accrual strategies to minimise interest rate risk do well during flat and high interest rates. The chart below shows how yields move in tandem with interest rates (repo rates).
Even seasoned investors find it difficult to take the right interest rate call. Investors can instead allocate their money to different debt fund categories of varying maturity. For instance, they can look at medium-duration funds such as corporate bond funds, banking and PSU debt funds, and dynamic bond funds. These funds tend to have their maturity profile in between the long- and short-maturity funds, thus they may provide the investors with the benefit of both the worlds. Corporate bond funds invest 80% of their assets in the highest-rated corporate bonds, and may invest a small portion in G-sec. They normally follow the accrual strategy, aiming to generate returns through the accrual of interest on bonds, which are mostly of shorter duration and are held until maturity. As a result, these funds are less exposed to interest rate volatility. Similarly, banking and PSU debt funds invest 80% of their assets in debt instruments of banks, PSUs, public financial institutions, and municipal bodies. Most of the schemes in these two categories aim to maintain an optimal balance of yield, safety, and liquidity. Their strategy is to mitigate credit risk and generate returns through a blend of accruals and active duration management. Meanwhile, dynamic bond funds can move across the maturity spectrum, based on the interest rate in the underlying market.
It is difficult for individual investors to take the right call on when to invest as per the interest rate scenarios. They might miss most of a market phase, landing up entering or exiting at the fag end of phases and missing superior gains. This is where SIPs can play an important role as regular SIP investments negate the need to time the market across different interest rate environments. Investors also have the opportunity to lower their average cost of investment, known as rupee cost averaging, by investing through SIPs. Further, debt fund SIPs can be used for an investor’s financial planning. Considering the anticipated future obligation and time horizon, investors with a low-to-moderate risk appetite can begin SIPs in appropriate categories to meet their goals, as an alternative to recurring bank deposits.
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