In Case Of Rising Interest Rate Scenario, What Type Of Debt Funds Is Best For You?

By BankBazaar | May 22, 2012

With high interest rates looming in the air, most investors are puzzled as to what type of funds should they opt for in order to promote a healthy growth of their investments. In such a scenario, debt funds should not be a probable choice since they operate on bond prices. The reason why it might not favor you is because there is an inverse relationship between the interest rates and bond prices. As the interest rates rise, bond prices come down thereby reducing the NAV (Net Added Value) of these debt funds. Similarly, in the eventuality of rising interest rates, there is a hike in the bond prices which leads to the rise in the NAV. Although, this phenomenon should not discourage you as an investor to completely avoid this option but instead, it should motivate you to carefully decide which debt fund to opt for before making any hasty decisions.

The best way to select debt funds is to primarily analyze their maturity period, apart from other factors like the quality of the assets and the liquidity they have to offer. If you are able to closely analyze these factors, your debt portfolio will be on the rise. The reason why short term funds are preferred is because they are not affected much with the volatility in the interest rate fluctuation in the short run. Only in the long term tenors, your investments need to be safe guarded against interest rate fluctuations.

Summarizing, if you want to enjoy higher returns, better liquidity and a certain degree of protection from interest rate fluctuation, short term debt funds will be advantageous. The only downfall will be in the performance of such kind of short term debt funds that depend upon the quality of the underlying paper, coupon rate and yield to maturity. So, choose them with utmost care and diligence.

Portfolio alignment:

As an investor, the two factors based on which you need to time your portfolio is to divide them into the following situations:

  1. 1. Falling interest rates:

In the falling interest rates scenario, you need to invest in income funds and gilt funds, which have a longer maturity period.

  1. 2. Rising interest rates:

In the rising interest rate scenario, liquid funds, ultra short-term funds and fixed maturity plans (FMPs), of a short duration, are the right choices.

Other Short Term Funds:

Liquid funds are valued at cost and are not marked to market and are considered to be a safer option in the constantly fluctuating interest rate scenario. Although the short term funds have a better protection of your investments, higher tax burden on dividends from liquid funds (25%, plus surcharge), is what you as an investor need to be aware of.

Most financial advisors advise that in case of a rising interest rate scenario, investors need to invest in liquid funds for the time being so that they can take full advantage of the rising interest rate scenario.

Liquid plus funds also known as Ultra short term funds are also safe haven during these volatile market conditions. Therefore, investors willing to invest for a span of 3-6 month can consider investing in this fund.

With the likely yield of around 9.5%, FMPs – Fixed Maturity Plans with a maturity period of 1 year are likely to outperform other debt investments. The reason being is that they are comparatively less sensitive to these interest rate fluctuations and can expect to generate good return in such a volatile market condition.

The only drawback that can be expected here is the lock in period. Your invested amount will be locked in for 1 year for which you will have an access only at the time of maturity. But as most financial advisors advice, FMPs can hedge the portfolio and reduce volatility when it comes to returns unlike short term funds and ultra short term funds.

Caution:

Apart from all these above mentioned advantages of the various short term funds, you as a prudent investor need to consider the performance of various types of funds under different categories before finalizing on any one fund. Remember it is your savings that is at stake. You do not want your financial statement to contain a debt like a personal loan, home loan etc just to fulfill your financial goals. You might have not expected your savings to fall short of your requirement but might be forced to opt for a loan on the eventuality of the interest rate fluctuation. Therefore make sure to have studied the features of your debt funds carefully before making any decisions.

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