Debt funds not performing well. What should be your mutual fund strategy now?

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The Reserve Bank of India raised the key policy rate by 50 basis points to 5.4% last week. The central bank had earlier raised rates in May and June by 40 bps and 50 bps, respectively. After two years of pause, the recent interest rate hikes are building pressure on the debt market. Debt mutual funds typically do well during low-interest rate scenarios. However, a rise in interest rates negatively impacts the returns from debt funds as the face value of debt instruments falls. Rate hikes amid rising inflation make investors worry about debt funds’ returns. Additionally, equity markets are volatile due to rising inflation and interest rate.
The question among mutual fund investors is what strategy they should adopt in the current scenario. The long-term return from debt schemes is relatively lower compared to their equity counterparts. Further, investors with low to slightly moderate risk appetites tend to choose debt funds for investments. Given the current state of high inflation verging on 8%, investing in schemes that cannot beat inflation is risky. Moreover, the difference between the return from debt funds and inflation would stretch further if more rate hikes were proposed.

Here is the mutual fund strategy that investors should consider amid falling returns from debt funds.

Look For Short-term Debt Funds

As the name suggests, short-term debt funds invest in short-term papers, and upon their maturity, capital is reinvested in better yielding papers. Investing in short maturity funds helps in minimising the losses due to yield rise and offers benefits of reinvestment at higher yields.

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Funds With Accrual Strategies

The accrual investment strategy refers to holding the paper (bonds) till maturity and taking the benefits of coupon payment. Debt funds which follow such a strategy considerably reduce the risk emanating from interest rate cycles, especially in a rising interest rate scenario. You may choose funds which follow a buy and hold approach as these are suitable options in a rising interest rate situation. While investing in such funds, it is advisable to stay invested till the maturity of the papers to have the optimum returns.

Invest in Target Maturity Funds (TMFs)

Target maturity funds follow an accrual strategy. These are primarily passive debt funds which track an underlying bond index. Such funds aim to help investors navigate the risks associated with debt funds by aligning their portfolios with the fund’s maturity date. Since they track the bond index, such funds tend to have portfolios comprising securities which are part of the underlying bond index, and thus have maturities in line with the fund’s stated maturity.

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TMFs are mandated to invest in government securities, state development loans or SDLs and PSU bonds. The fund’s portfolios hold all these bonds or securities to maturity. This ensures that the fund’s duration keeps reducing with every year. Thus investments are less prone to price fluctuations caused by interest rate changes, thereby adding predictability of returns. Risk-averse investors may consider TMFs in their portfolios.

Debt-oriented Balanced Funds

Balanced funds that invest dominantly in debt can also be opted by risk-averse investors to increase their investment yields. About 65-70% of the portfolio of such funds is invested in debt instruments, while the rest is in stock-related instruments. Having a balanced investment strategy does help when there are uncertainties around the various asset classes.

Balanced Advantage Fund

These are dynamic asset allocation funds which offer investors benefits of both debts as well as equity investments. Given the changing valuations, such funds can take the equity exposure to as high as 80% and reduce it to a low of 20%, while the rest of the investments is made in various debt securities. Since such funds work on buying low and selling high, investors benefit from the continuous asset allocation strategy. Though the returns may not be as high as in the case of pure equity funds, the generated yield will comfortably beat inflation in the medium to the long-term investment horizon.

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Investors can choose from a plethora of debt fund categories according to their risk-taking capacity and financial goals and create wealth through debt funds in the various cycles of interest rates. However, there are certain equity-related dynamic asset allocation funds which moderately conservative investors may also choose as a strategy in the current scenario.

(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.timesnownews.com.)

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