Short-term debt funds reduce rate volatility, offer good returns

Short-term interest rates are currently elevated and the yield curve is likely to remain pressured, driven by higher inflationary expectations . The long-term interest rate scenario is uncertain, given the rapidly changing macro factors – both local and international, with the key variable being crude prices and their impact on the fiscal situation. This provides an ideal backdrop for investing in shortterm debt funds. As the name suggests, shortterm debt funds or short duration funds are mutual fund products investing in debt securities that lie at the shorter end of the maturity spectrum.

More specifically, these schemes predominantly invest in debt securities with maturities ranging from three months to about 18 months. Accordingly, these products are positioned between liquid funds, which invest in short-term liquid money market instruments with maturities of up to 91 days and medium to long-term debt funds, which invest in long-dated securities (instruments with maturities that are typically between three and 10 years). The average maturities of short-duration funds range from 0.60 to 1.5 years and depend to a large extent on fund managers' rate views as well as the prevailing shape of the yield curve.

Two-Pronged Benefit

Investing in short-duration funds enables an investor to benefit from regular coupon accruals. Further, since these funds have a lower average maturity than income (bond) funds, the returns volatility tends to be minimal in a rising, uncertain interest rate environment. On the flip side, if rates trend downwards, investors stand to benefit from the possibility of capital gains, in addition to the coupon accruals.

Elevated Yield Curve

Given the tight monetary stance adopted by the RBI and the underlying tight liquidity scenario, the yield curve for most of fiscal 2011 was inverted. So effectively, shortend rates (ie, yields on products with maturities of up to 12 months) traded at higher rates than similar instruments with maturities of 3, 5 and 10 years. For instance, at present a 12-month CD trades at around 9.80% while a 10 year triple-A-rated corporate bond is traded at 9.20%. Accordingly, short-duration funds present investors with the prospect of leveraging the elevated rates at the short end of the curve, given the uncertainty in the longterm rate scenario.

Hazy Interest Rates Horizon

Currently, there is uncertainty over the long-term interest rates. The market expects the RBI to further raise rates to tame the rising inflation. As things stand, inflation came in at 8.98% for March. This was well above the expectations of around 8.38% and higher than the RBI's own target of 8% for the end of fiscal 2011. In the medium-term , too, inflation expectations are high as the market anticipates the secondary impact of fuel prices on the back of rising crude oil prices. Over the last four months, oil prices have risen by 30% and the impact will be felt with a lag once the government passes on the burden to the economy . Due to the prevailing high inflation , the RBI is expected to hike interest rates until inflation expectations and inflation itself come under control. As inflation and credit growth remain high, liquidity could be under strain in the coming months, which would also exert upward pressure on the rates. Given this backdrop, the long-term interest rate outlook is fluid. In addition, the government has only just begun its GSec auctions for FY 2011-12 .

Best Of Both Worlds

Given the combination of currently high coupon rates and the uncertain interest rate outlook, shortterm debt funds offer you the best of both worlds – mitigated volatility and attractive coupon income.

Source: http://articles.economictimes.indiatimes.com/2011-06-14/news/29657146_1_debt-funds-liquid-funds-rate-scenario/2