Debt investments in times of rising interest rates

DEBT INVESTMENTS IN TIMES OF RISING INTEREST RATES

Everyday one reads press releases of banks announcing a rise in their lending rates as well as deposit rates. This is the result of rise in economic activity (read investments), which has led to tight liquidity in the market. With demand for money exceeding supply, interest rates are looking up-wards. The finance ministry has been assuring that the situation is under control and has also instructed the Central Bank (RBI) to release funds into the market to increase liquidity. And yet, interest rates have raised their heads upward.

The implications

With every change, a smart investor should consider how to en-cash on the opportunity the change brings. In this case, with the possibility of an upward movement in interest rates, one should consider debt mutual funds. However, there are a number of types of debt-funds. Each fund type, depending on its portfolio maturity (funds investing in debt securities with short tenures have short portfolio maturity while those investing in debt securities with long tenures have long portfolio maturity) responds differently to rise in interest rates.

Debt Funds with short-term Portfolio Maturities

Debt funds with short portfolio maturities are better off during rise in interest rates since they are able to shift to high rate debt securities more easily. This is because they are not locked into long-term debt paper offering low interest rates. For instance, a debt fund which has invested in a debt security offering 5% interest whose balance tenure is 10 years, will see a fall in the market value of the debt paper with Interest rates rising. However, a debt fund which has invested in a debt paper offering a lower interest rate (say 4%) whose balance tenure is say, 1 year, will not see much of a fall in the market value of the debt security in case of a rise in Interest rates.

The long-term outlook on interest rates is still hazy whereas short term rates are attractive. Investors should look at funds with a low average maturity portfolio such as liquid funds, short term funds and floating rate funds.

Liquid Funds

These funds have an average portfolio maturity of between 1 day and 2 years. The minimum investment amounts range from Rs. 500 to Rs. 1lac. These funds don’t charge any entry or exit loads. Average 1-month, 3-month, 6-month and 1-year returns are offered by these funds. Current returns offered are 0.47 %, 1.31 %, 2.55% and 4.94% respectively.

Short-term Debt Funds

These funds have an average portfolio maturity ranging from about one week to about 3 ½ years. The minimum investment amounts range from
Rs. 500 to Rs, 1 lac. No entry load is levied by these funds. Usually exit load, too, is not levied. However, if the exit is within7 days to three months, some funds charge an exit load of between 0.25 % and 1%. Average 1-month, 3-month, 6-month and 1-year returns offered by these funds at present are 0.53%, 1.11%, 2.20% and 5.03% respectively.

Floating Rate Funds

Floating rate funds mainly invest in-debt securities with floating interest rtes. Floating rate debt securities are instruments wherein the interest rate is linked to a benchmark rate. When the benchmark rate moves upwards or downwards, the interest on the floating rate security moves accordingly

Long-term Floating Rate Funds

The average portfolio maturity of these funds ranges from about 45 days to about 2 ½ years. The minimum investment amounts range from Rs. 500 to Rs. 25,000. No entry load is levied by these funds.

An exit load of between 0.3 % and 0.5% is charged for exit within 3-6 months. Average 1-month, 3-month, 6-month and 1-year returns offered by these funds in April 2006 are 0.46 %, 1.29%, 2.56% and 5.28% respectively.

Short-term Floating rate Funds

The average portfolio maturity of these funds ranges fro about 28 days to about 2 years. The minimum investment amounts range from Rs. 500 to Rs. 1 lac. No entry load is levied by these funds. Usually, no exit load is levied, too. Average 1-month, 3-month, 6-month and 1-year offered by these funds as on 8 April 2006 is 0.48%, 1.37%, 2.74% and 5.52% respectively.

Fixed Maturity Plans (FMPS)

Anthony Heredi, Head Sales & Distribution, HSBC Mutual Fund says, “ In a scenario of rising interest rates, it is advisable to invest in a combination of liquid funds and fixed maturity plans, “ FMPs are close-ended debt funds, which invest in debt securities matching the tenure of the fund. For instance, a 1-year FMP will invest in a 1-year debt security. Here, the FMP investor has a clear indication of what return his FMP investment will offer. In order to offer a FMP, the mutual fund has to locate a debt investment with adequate safety and offering an acceptable return. Such debt paper is not easily available. There is a higher demand for such investment than supply and hence, mutual funds don’t need to actively market and promote such schemes. One can find about FMPs open for investment from the mutual fund distributors. Presently, indicative returns offered by FMPs are in the range of 6 to 8 % depending on the tenure.

Conclusion:

If an investor has a strong disinclination towards equity and has been tolerating low returns on debt investments, one need not do so The investor can become a smart debt investor by keeping a vigil on movement in interest rates and capitalizing on any rise or fall in interest rates.