How debt funds can beat inflation and interest rate risks?

Rising inflation and interest rate changes can affect debt fund yield but there are ways to manage this effectively.

To diversify risk exposure, a typical investor builds a portfolio that comprises different investment categories such as equities, debts, precious metals, overseas stocks etc. Equity investments stand a better chance to yield higher results, and inversely, incur sudden losses too. However, debts funds assure you a regular income and a predictable rate of return. Debt mutual funds are classified under conservative investment options that are low on risk and reward. 

As an investor, you will be investing in debt funds in some proportion. What you need to ensure is: can your investment beat inflation and interest rate risks? 

The big question

As an investor in debt funds, you are assured of the risk mitigation that debt fund brings in. A steady and regular return to insulate market uncertainties is fine, but it should be good enough to beat inflation and interest rate uncertainties. 

Inflation weakens our standard of living by lowering the purchasing power of money. If the investments you make do not yield a return that is higher than the prevailing interest rate, the investment is losing out on its worth. Presently, the inflation in India is expected to continue as the supply side is yet to fully recover from the pandemic. 

With the economy on a recovery path and inflation set to rise, further lowering of interest rates is unlikely to appear in the near future investment horizon. A rate hike too is unlikely as this would increase the cost of borrowing and hinder economic recovery.

With rising inflation and a stagnant interest rate, the growth prospect of debts funds is not particularly rosy. Now, the longer the duration of the debt fund, the higher is the interest rate risk attached to it. With the focus shifting to short- and medium-term debt funds, experts are advising investors to avoid standalone long-term debt funds due to the higher interest risk. 

Therefore, it is safe to assume that short- and medium-term debt funds are preferable if one wants to beat interest rate risks under the current rising inflation and paused interest rate scenario.

Related: How debt and equity based mutual funds differ in risk

Short- and medium-term debt fund options

The choice of fund will depend on the risk appetite of the investor and the cost of funds. Mentioned below are some of the debt funds that carry low to moderate levels of risk. 

• Short-duration funds are open-ended short-term debt funds that invest in marketable securities. These funds have a duration of 1-3 years and moderate interest risk. Their credit risk can be moderate to moderately high. The expected yield-to-maturity (YTM)* rate is 4.96%.
• Medium-duration funds invest in debt and debt-related instruments and are open-ended. These funds have a duration of 3-4 years. They have moderate to moderately high credit risk and moderate interest rate risk. Their YTM rate is 6.33%. 
• Corporate bond funds are of the duration of 1-5 years and have a moderate interest risk. However, their credit risk is relatively low. These funds invest in highly rated corporate bonds and have a YTM rate of 5.24%. 
• Banking and PSU debt funds are identical with corporate bonds in terms of risk and duration. These funds invest at least 80% of their total assets in banks, PSUs, and public financial institutions. The expected YTM rate on these funds is 5.19%. 

Related: Confused by multiple debt instruments? Here’s how to choose the right one [Premium]

On the other hand, the following debt funds rate low on both interest rate risk and credit risk:

• Low-duration funds are open-ended fund schemes that invest in debt and money market instruments for a period less than one year. The YTM rate for low-duration funds is 4.26%.
• Ultra short-duration funds are open-ended funds with a duration of 3-6 months. They mostly invest in securities. A 3.82% YTM rate can be expected from these funds.
• Overnight funds can be used for investments as short as a day. Investments are made in overnight securities and can be used by investors as an emergency fund. Around 3.22% YTM is expected from overnight funds.
• Liquid funds invest in debt and debt-related instruments for a maximum period of three months. Liquid funds are expected to have a YTM of 3.3%.
• Money market funds are invested in liquid debt instruments, including cash equivalent and treasury bills, commercial papers, highly rated debt securities etc. These funds can bring in 3.6% YTM returns.

*All YTM rate as of February 2021, estimated by iFast Research.

Related: Puzzled about debt funds? Here are answers to six common questions

Long-duration debt funds do offer higher returns but at the cost of a higher interest rate risk. In any debt fund decision, short-term and long-term capital gains must also be considered. The response of the RBI to rising inflation, particularly through interest rate changes, also needs to be monitored. With these things addressed, investors can expect to stay ahead of inflation and manage interest risk with their debt fund investments. Know these different types of funds available under mutual funds.