Interest rates have been on the rise over the past year. Even before the RBI embarked on its rate hiking cycle this year, the yield on the 10-year government bonds had been inching up. Over the past year, government bond yield has gone up by about 140 bps. But what does this move in interest rates mean to you as an investor in debt mutual funds?

For most of us, jargons such as ‘duration’ or ‘accrual strategy’ — often used while making investment decisions in debt funds — can be confusing. It is important to understand them and make the right choice.

Here’s a ready reckoner for your investments in debt funds.

What impacts bond prices

While it’s true that debt funds are not as risky as equity funds, some portion of your initial investment can, nonetheless, get eroded. The net asset value (NAV) of a debt fund can rise or fall, along with the underlying bond prices. Debt funds invest in various fixed-income instruments such as government bonds, corporate bonds and other money market and short-term debt instruments.

Bond prices and interest rates are inversely correlated to each other — if interest rates move up, bond prices fall. This is because investors flock to newer bonds that offer higher rates, after exiting old ones. This reduces the attractiveness of older bonds, and hence, their prices decline.

Longer-duration bonds are more sensitive to interest rates. Hence, in a rising rate scenario, such as what is prevalent now, fund managers reduce the ‘duration’ of the fund to cap losses.

Duration vs accrual

Aside from interest rates, the underlying credit risk of bonds in the debt fund portfolio also impacts returns. Some debt funds capitalise on interest receipts rather than gains from bond prices. This means they earn higher interest by investing in lower-rated (AA rated and below). These funds suffer losses if the company issuing the bonds defaults on its repayments, or when rating agencies downgrade the rating on these bonds.

Hence, debt funds can either follow a strict ‘duration’ or ‘credit’ call. They may also blend the two strategies.

Which strategy to go for

In a bid to standardise schemes across fund houses, SEBI has mandated 16 pre-set categories under debt funds, based on duration and credit risk.

For conservative investors looking for alternatives to bank savings deposits, liquid funds and very-low-duration debt funds fit the bill. These funds carry the lowest risk among debt funds, as far as rate risk and credit risk go. As per SEBI’s categorisation, liquid funds invest in debt securities with a maturity of up to 91 days, and ultra-short-duration, low-duration and money market funds carry durations of up to six months, 12 months and a year, respectively.

These funds, on an average, have delivered 7.5-9 per cent returns over the past 5-7 years. L&T Liquid, Principal Cash Management, SBI Magnum Low Duration, Franklin India Low Duration and Franklin India Ultra Short bonds are some of the steady performers within these categories of schemes.

If you have a slightly higher risk appetite and a longer time horizon of, say, 2-3 years, you can consider debt funds, which generate returns both from accruals and duration calls (only moderately). Under the new avatar, debt funds categorised as short-duration (1-3 years), medium-duration (3-4 years), corporate bond funds (with 80 per cent allocation to highest-rated bonds) and banking and PSU funds (mainly investing in debt papers issued by banks and public sector undertakings) are good choices. These funds have delivered 8-9 per cent returns over the past 5-7 to seven years. Axis Banking & PSU Debt, Tata Corporate Bond, Aditya Birla SL Medium Term Plan and HDFC Short Term Debt are some of the steady performers in this category.

For those who have a higher penchant for risk, credit-risk funds (investing a minimum of 65 per cent in low-rated bonds) and dynamic bond funds (investing across duration) may be ideal in the current scenario. Credit risk funds allow investors to cash in on higher yields, while dynamic bond funds offer the opportunity to make use of interim rallies in bond prices. These funds have delivered around 8.5-9 per cent returns in the past. SBI Credit Risk, UTI Credit Risk and Franklin India Dynamic Accrual are some of the top performers in these categories.

Given the current up-trend in interest rates, investors should avoid long-duration funds (with duration of more than seven years), as well as gilt funds. While they can generate double-digit returns in favourable markets (when rates fall sharply), they can lead to significant losses when rates move up sharply.

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