Stable Returns Rain or Shine: Why Short Term Debt Funds Are Your All-Weather Friend

Synopsis

Short-duration funds make investments in short-term debt instruments so that the portfolio's overall Macaulay duration stays between one and three years.

On a risk-adjusted basis, the short-duration debt fund category appears appealing. It chooses bonds or loans for investment such that the average maturity term for the portfolio is between 1-3 years.

Over 1 year and 3 year periods, the short-term debt category has yielded profits of 6.35 percent and 5.43 percent, on average, respectively.

Across interest rate cycles, short-duration funds should provide comparatively greater returns. The primary sources of revenue for these funds are accruals and capital gains on short-term calls.

The medium-term forward-looking inflation, real rates, and spreads (above and beyond the Policy Repo Rate) are the primary drivers of benchmark yields.

Based on the aforementioned fundamentals, yields have historically shown a propensity to converge.

Real rates are predicted to increase to 2 percent compared to the historical average of 1 percent and the RBI's long-run comfort levels of 0.8–1 percent, given a 1-year forward-looking inflation estimate of 4.5 percent. Given that actual inflation is tracking forecasts, which call for 3.8 percent inflation in the second quarter of FY2025, markets are expected to factor in rate reduction to maintain the momentum for continued growth.

Furthermore, benchmark yields typically narrow the spread between G-Secs and the policy repo rate before the central bank takes any action on interest rates. The spread between the preceding yields is 65–70 basis points (bps).

Owing to robust fundamental and technical factors, offshore market participants have shown a great deal of interest in domestic government bonds.

To further encourage active investor appetite, sovereign bonds have been added to the JP Morgan & Bloomberg EM indices.

While index-related flows are anticipated to start for the JP Morgan Index in September 2024 and the Bloomberg EM Index in January 2025, the markets saw substantial flows into sovereign bonds from October 2023 to March 2024, totaling Rs 80,000 crore.

With these considerations, the short-duration category appears appealing when taking risk into account.

Debt funds have a number of advantages. They can be a useful complement to a long-term investing portfolio and aid with emergency corpus planning. Long-term debt fund holding offers better returns than fixed deposit while lowering exposure to interest rate risk.

Author : Prayas Sarkar, MBA FInance

Post Graduate Programme of Financial Markets

NISM VA, NCFM Capital Market Dealer Module