In 2022, interest rates / bond yields were moving up. It was driven by reasons like rate hikes by the RBI, banking system liquidity surplus moving from surplus to neutral, global inflation being much on the higher side, rate hikes by central banks globally, etc. Bond yields and prices move inversely, and NAV valuation of debt funds was happening at lower prices. That being the case, why is the impact different in various categories of debt funds? There are two reasons. Longer the portfolio maturity, higher is the impact of rising interest rates. This is due to a metric known as modified duration, which gives the indication of the impact. Higher the modified duration, higher is the impact. Liquid Funds have very low portfolio maturity and modified duration, hence the adverse impact is lower. As we move up the ladder of portfolio maturity and duration, the impact of market movement becomes progressively higher. That is what happened in 2022.
The other reason is, time taken to recover the temporary loss due to adverse movements in the market is lower for funds with shorter portfolio maturity. On maturity of an instrument in the portfolio, the face value is realized, though the earlier valuation for NAV was lower. In a Liquid Fund, instruments are due for maturity after say one week or one year. In a longer maturity product, instruments fall due for maturity after multiple years. Net-net, 2022 has been suboptimal for debt funds, returns being lower than bank deposits.
However, to put in perspective, one year is not the correct way to look at debt funds. There is a requisite holding period for all categories of debt funds. There are favourable years and not so favourable years. Over an adequate holding period, performance evens out. This happens due to the portfolio accrual- that is, the interest that is earned on the instruments in the portfolio. Moreover, market cycles have happened in the past, and will happen in future as well. As long as you have a holding period horizon on your side, you can ride across market cycles.
If we have to look at it in terms of favourable and unfavourable years, 2023 will be much better for debt funds. Interest rate increases in India are almost over. Barring may be one last rate hike by the RBI, we are more-or-less done with it. When interest rates are stable, the adverse market movement that happened in 2022 is not expected to happen in 2023. Debt funds will deliver accrual based returns, which is the interest due on the various securities in the portfolio. It is expected that in 2023, the RBI would stay put on interest rate decisions, after maybe one more rate hike in February or April 2023. Interest rates are expected to remain more-or-less stable, at least not be as volatile as in 2022. The implication is, in 2022, interest rates moving up in the market took away from the accruals, which is not expected to happen in 2023. Subsequent to RBI rate hikes, interest rates have already moved up and the accrual levels are better than earlier.
In 2023, investors need not be defensive in debt fund investments, e.g. resorting to Liquid Funds for a horizon of a few months or longer. There are multiple debt fund categories, 16 as per SEBI classification. Moreover, there are Target Maturity Funds where there is a clearly identifiable maturity date and high visibility in return expectations. In these various fund categories, investors have to choose the ones that are appropriate for the investment horizon e.g. few months or few years. There are Corporate Bond Funds and Banking and PSU Funds, that are appropriate for a horizon of 3 years and longer. For shorter horizons of say 6 months, there are Low Duration Funds and Money Market Funds. G-Sec Funds are advisable only for long horizon of say 5 years or 10 years. Net-net, in 2022, debt mutual fund products will be competitive with bank term deposits. If you have a horizon of 3 years and longer, you will have tax efficiency as well, which will make it even better than term deposits.
(Joydeep Sen is a corporate trainer and author.)
