Why exiting liquid funds may be a good idea amidst the likely rise in interest rates

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When inflation is projected to be around 5.3 percent for the rest of the financial year, investors cannot ignore the real interest rates – nominal rate of interest minus inflation.

For a one-year fixed deposit that pays around 5 percent, the real rate is negative. The post-tax return looks worse. Though interest may be a bit higher for long-tenured bonds, it makes no sense to lock in, as rates are expected to rise. Even if you are content with current yields and want to hold on to investments till maturity, you are bound to experience volatility as interest rates move up.

Impact of staying invested in very short-term avenues

Liquid funds or very short-term fixed income investment options look safe, if you think that interest rates would go up. The strategy here is: wait till rates rise, then switch from short-term investments to 1-3-year fixed deposits or short-term bond funds.

Similar is the case with liquid funds, wherein the portfolio yield to maturity is 3.6 percent whereas a short duration funds delivered around 4.9 percent and medium duration funds gave 5.9 percent. “When you allocate money to liquid funds instead of a short or medium duration fund, you make low returns. Investors with long enough holding period should not remain invested in liquid funds just because interest rates are likely to rise,” says Joydeep Sen, Corporate Trainer-Debt.

Vibhor Mittal, Chief Product Officer of CredAvenue, says, “We expect one repo rate hike and around 25 to 40 basis points increase in interest rates by March 2022. As the rates appear to have bottomed out, it makes no sense to invest in long-term bonds. But at the same time, investors cannot ignore the fact that very short-term fixed income avenues such as liquid funds are delivering very low returns.”

A note issued by IDFC Mutual Fund earlier, recommends investments in medium-duration government securities. The spread between one-month overnight rates and six-year government security stands at 255 basis points compared with a five-year historical average of 139 basis points. A basis point is one-hundredth of a percent point.

“Investors trying to time the market by staying put in the short end of yield curve with plans to deploy their money in duration products after the rates rise are missing out on the potential yields available on medium duration (4-6 years) bonds and the roll-down benefit,” says Sirshendu Basu, Head-Product, IDFC Asset Management Company.

What should you do?

Investors should not ignore their cash flow requirements. “While choosing bond funds, investors should ideally match their investment timeframe with the duration of the fund. Target maturity bond funds can be considered if you are comfortable holding them till maturity,” says Joydeep Sen. This strategy ensures that you are least hit by changes in interest rates, he adds.

If you have a four year timeframe, then a medium duration fund with around a four-year duration suits your needs. But here is a word of caution – you may see some marked-to-market losses if interest rates move up fast.

Vishal Dhawan, Founder & Chief Financial Planner, Plan Ahead Wealth Advisors recommends the use of bar-bell strategy. It calls for investing your capital in two segments – some in liquid funds and the rest in short to medium-duration funds. “While the investment in short to medium duration funds earns a higher yield, the liquid fund exposure reduces the overall impact of interest rates movements on the fixed income portfolio,” he says. Investments in liquid funds can also be used as emergency funds.

In case of bonds that have no default risk, the marked-to-market downside arising out of interest rate movements is temporary in nature and those holding till maturity, will get paid.

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