Is it a right time to switch to Short Term Debt Mutual Funds

Can I generate higher returns compared to traditional investment products without any risk? This was the query posed to me by one of the clients. The answer is definitely YES. At this stage, it is advisable to switch to Short Term Debt Mutual Funds. Now you must be wondering why? I will answer it in this post with proper justification.

Before I proceed, It is important to know the impact of interest rate movement on the performance of Long term debt funds and Short Term Debt Mutual Funds. I explained it in detail in my post, why you should buy long term debt funds? The conclusion was that long term debt funds perform well when the interest rates decrease. In other words, if REPO Rate is cut then G-Sec yield of 10 years or Govt of India Bonds decreases. It will increase the bond prices thus long term debt funds perform well. With an increase in Repo rate, the interest rate increases thus G-Sec yield of 10 years or Govt of India Bonds also increases. It results in a decrease in bond prices thus long term debt funds under perform and then Short Term Debt Mutual Funds pitch in.

The performance of Short Term Debt Mutual Funds is the reverse of long term debt funds. In short, in the case of a decrease in the interest rate, the Short Term Debt Mutual Funds does not perform well. On the other hand, if the interest rate increases then the Short Term Debt Mutual Funds perform really well and may deliver double-digit returns. To summarize, under current scenario the interest rates have bottomed out. Therefore, the reversal of interest rate cycle is around the corner. Thus I am of the opinion that it is the right time to switch to Short Term Debt Mutual Funds. They can potentially deliver double-digit returns like long term debt funds when the interest rates decreased.

You can also check out a post on various types of mutual funds and how to start investing in them

Interest Rates bottomed out – 5 Reasons to Switch to Short Term Debt Mutual Funds

1. G-Sec yield of 10 years or Govt of India Bonds are ahead of times:

In an ideal scenario, the Repo Rate and G-Sec yield of 10 years or Govt of India Bonds should be equal. Normally, it does not happen. A small/minor deviation between the two is acceptable. Please note that there is a strong correlation between the two.

I receive large no of queries on how an investor can find out or predict the future interest rate movement. The answer is very simple. By keeping track of the difference between Repo Rate and G-Sec yield. In my opinion, the G-Sec yield is ahead of times. In laymen terms, if the G-Sec yield is substantially lower than Repo rate, the interest rates are expected to fall. On the other hand, if the G-Sec yield is substantially higher than the repo rate then the interest rates are expected to increase. As of today, the G-Sec yield of 10 years or Govt of India Bonds is 6.79 and RBI’s repo rate is 6.25%. There is a sharp increase in recent past. Therefore, interest rates are expected to increase in future. Thus Short Term Debt Mutual Funds are expected to perform better.

Another simple way for investors to find out interest rate movement is to check the AUM of various types of debt mutual funds. It gives a fair indication of the market’s view on the movement of interest rate. For example, if there is outflow from long term debt funds, it means interest rates are going to increase and vice versa. On the contrary, if there is outflow from Short Term Debt Mutual Funds then interest rates are expected to fall and vice versa. Please note that this is my personal conclusion :).

2. RBI and Banks Signal:

Even though RBI or RBI governor does not share media bytes too frequently but the last couple of interactions with media during bi-monthly policy reviews enough hints are dropped that interest rate cycle has bottomed out. The same sentiments are acknowledged by the top management of the leading banks.

3. Analysts and Brokerages:

The large no of analysts and some prominent brokerages are expecting that interest rates will start increasing from the first half of 2018. These inputs are very important as there will be large scale rejig in debt market. Therefore, besides the natural impact of interest rate increase on Short Term Debt Mutual Funds, it is anticipated that there will be a sharp increase in returns due to demand-supply mismatch. In short, there will be a shift from long maturity bonds to short-term maturity bonds.

4. Lower base inflation:

This is most crucial and deciding factor for interest rates. Post demonetization, the inflation cooled off and it was less than 3% recently. It is never heard off in recent past. The base effect of inflation means inflation during the corresponding period of the previous year. Due to low base effect, a slight increase in prices next year will result in higher inflation. Maybe this is one of the reasons why analysts are anticipating and predicting higher interest rates next year. There is also anticipation that GST will have an inflationary pressure.

5. Crude Oil Prices:

Last but not the least and very important point is that crude oil prices are expected to increase in future. The reason being OPEC may cut down the supply. The crude oil is bread and butter for many oil producing countries. The prices more than halved in last few years. It makes some of the oil producing countries restless. The prices are driven by demand and supply. Therefore, any cut in the supply will have an incremental effect on the prices of crude oil.

Now you must be wondering why I am discussing crude oil prices in my post. The reason being crude oil prices will have a maximum inflationary effect. It is one of the most crucial points to decide the interest rate direction. Any increase in crude oil prices means an increase in inflation thus increase in interest rates.

Check out: Debt Mutual Funds – 7 Hidden Risks

Words of Wisdom:

A retail investor can play around with the interest rate movement to generate double-digit returns. In the case of passive investors who cannot manage their portfolio actively can invest in dynamic bond funds. In these funds, the fund manager decides the average maturity of the scheme as a whole to take advantage of interest rate movement.