The Mutual Fund Show: How To Navigate Higher Interest Rates

Uday Dhoot: Essentially, debt mutual funds are buying in interest accruing bond securities. The basic principle of any kind of bond investment is that when the interest rates go up, bond prices go down; and when the interest rates go down, the bond prices go up. Basically, interest rate and prices of bonds are inversely related.

Because mutual funds, unlike fixed deposits, have to be priced on a daily basis, the NAV gets priced based on how the bond securities are being priced. So, if interest rates go up, bond prices will go down. To that extent, NAVs of debt mutual funds will go down.

Within the debt category, there are various types of mutual funds. There is something called overnight funds and there are long duration G-Sec funds.

The interest rate risk of a debt mutual fund, which is basically how violently the NAV of the debt mutual fund will react to interest movement, depends essentially on the duration. The longer the duration of the underlying debt security or debt mutual fund that you hold, the higher will be the impact on the prices when the interest rates go up. The lower the duration, the lower the risk. So, if interest rates go up, debt funds are likely to see temporary negative returns — and temporary is an important bit here.

This impact may not be seen in overnight funds, in money market funds, because they hold very low duration securities which mature very quickly.

If a fixed deposit was listed, its price will keep going up and down as interest rates move. But if you hold the fixed deposit until maturity, and the company pays up the principal and the interest, you will still get what you were promised when you entered that investment. The same thing will happen with the debt security that you hold in your investments.

When talking about existing investments, this is an investment that could have been done maybe six months back, one year ago, or three years ago.

You need to think through your portfolio and figure out what kind of decision to take: How long have you been holding these investments? What is your investment horizon? What is your tax status – which tax bracket do you belong to? What is the underlying debt portfolio that you hold?

Let's say you're expecting interest rates to go up, and to that extent, chances are that debt fund returns might turn negative temporarily. What should you do? Ideally, you'd want to get out of that fund and invest in some other fund which will not react or get impacted in the same manner.

But every time you get out of a debt fund, you will have to pay capital gains tax. If you are holding the debt fund for less than 36 months, you end up paying tax as per your tax bracket.

Let's say you've been earning 5% or 6% return on a debt fund today; it has not completed the 36 months window. You get out and pay almost one-third if you are in the highest tax bracket. Basically, 2% goes away straight as tax. Does it still make sense for you to move? Maybe not. Maybe, you are okay to live through that volatility for some period of time and stay invested.

Map your investment horizon with the type of debt funds that you have: What is your holding period? How long will it be before it becomes long-term, and then take a decision.

Typically, if you are holding roll-down schemes, target maturity debt funds, floating rate funds, ultra-short duration funds – and if your investment horizon matches with what you pulled – and obviously overnight in money market funds, then maybe there’s no need to do any changes.

But if you are holding long duration funds, and you want to step aside from the volatility for some time, maybe if the tax impact is very low, you want to get out and get back in.

Uday Dhoot: The general optimisation in debt funds is not very high. Like if selecting A debt fund versus B debt fund, the return differential will not be 3-4%, which is why the tax consideration on changing of debt fund becomes that much more critical.

You need to be aware of the cost – both of the fund as well as the tax – before you start making those changes.

Coming back to the question of new investors – if you have a three-month bucket and if you are ultra conservative, then maybe stick to the money market and overnight funds for some time. Within the overnight or money market funds, you can have an HDFC, ICICI, Kotak or SBI. All of them have funds in these categories. You can choose anyone. There's really not much to choose between A versus B.

If you want to earn a slightly higher return, then maybe you would want to look at ultra-short duration funds – again from IDFC, HDFC, Kotak, SBI – really not much of a difference between these schemes as such. So, for three months, overnight money market or ultra-short is what you should be looking at.

Uday Dhoot: In terms of returns, the ultra-short duration funds will basically be holding three months to six months securities. The money market will hold anything less than three months.

They get priced very quickly. So, to that extent, it will carry less interest rate risk. The return deferential will be maybe 20-25 basis points. The whole point in debt is that over-optimisation may not be a great idea, because optimising just yields so much.

If one is looking at a one-year investment horizon, you would still stick to an ultra-short duration fund, which will maybe give you a decent return.

As interest rates go up, because they are holding six months securities, they will get higher yield to maturity maybe three months or six months later. So, your net outcome four or six months down the line might be decent.

The other possible option would be the Bharat Bond FoF 2023, which is basically maturing after one year. I think that fund is yielding maybe around 4.95 % at the moment. So, that is the other option that you have. There’s really not much in terms of optimisation available within debt funds, so don't trade much. Stick to whatever it is and maybe when you get opportunities in other asset classes, use them.

Uday Dhoot: In debt, it is safety and liquidity (that matters).

Uday Dhoot: Data is clearly favouring index funds in the large-cap category. Over a period of time, SEBI has got very categorical in terms of what is ‘large cap’ and the definition has become very strict. To that extent, the maneuverable capability that the fund managers had has gotten limited. To that extent, the Alpha generation capability has got limited.

Whereas an actively managed large-cap fund will have a higher expense ratio, you are now getting index funds basically free of cost with some of the newer MFs that are coming through. So for them to generate extra returns might get tougher.

Incremental money to large cap from new investors and existing investors should definitely go to index funds or ETFs.

For existing investors, the call might be dependent on tax implications. If somebody has been investing over the course of the last two or three years, you are sitting on decent capital gains and the cost will be upfront. If you are selling and moving to a large cap, it will need paying taxes upfront. So maybe you want to check that first before you take a decision. I don't know if switching is so critical right away. Maybe we'll get more opportunities to do that, but incremental money should go into index and ETFs.

Uday Dhoot: As an advisor, I am not as well-equipped as a fund manager to pick up sectors and segments within sectors which are going to do well. I'm better at working with clients in building a portfolio.

Sectoral funds, barring a few, are funds that are good to enter and exit. They are not just buy-in and hold forever kind of categories. For them, equity diversified funds are better. To that extent, most investors should not do sectoral funds.

If you're doing an equity diversified fund, if a sector is likely to do well, any fund manager who's managing the money will invest more money in that sector. You don't need to double it up for yourself because you will then have to figure out when to get into the sector and when to get out.

We have seen that the biggest of losses or disappointment for almost all investors happened in sectoral funds. This happened in 1999 with the IT sector fund; it happened in 2007-2008 with the infrastructure funds. So, sectoral funds as a theme remain something which creates the biggest disappointment for investors. I would say don't do sectoral funds in most cases.

Now, we have noise on both sides. India has been talking about Atmanirbhar Bharat for a very long time. Globally, (because of) what is happening between Russia and Ukraine, every country is now talking about self-reliance in certain areas, because you can’t depend on any country if something happens with your country. To that extent, defence budgets across the globe will go up. Maybe this will play out well.

But the point is, we don't know when things will suddenly change. For one month, people were guessing when the Russia-Ukraine crisis would start and people said nothing will happen and then suddenly all of this happens.

Common people and certain investors won't even know what has changed in the world. You are better off holding equity diversified funds. Your fund manager is listening to all the news across the world, figuring out which segments to go after.

If after seeing all of this, some people are still keen to invest some part of their money in thematic funds, I think ICICI has a Fund of Fund called the ICICI Pru Thematic FoF, which is essentially a fund of funds which invests in other sectoral funds. The fund managers take a call as to which sector they want to invest in and which sector they want to get out of. That is a good fund to invest in if you want a slightly aggressive thematic sectoral kind of approach.

There are two advantages of something like this: You get better decision making because it is the fund manager who is taking a call on sectors to get in and get out of, and possibly they have more resources than any one of us have to get into a sector. Secondly, it is more tax efficient. Every time we trade in and trade out – and this is a big thing that all investors should know – it creates expenses in terms of tax outflow. So, if you're investing in a fund like this, they are selling and selling out, getting into another sector, but no capital gains accrue to you unless you get out of that fund. So, it is basically more tax efficient and obviously you should have better decision making, given the resources that they have at hand.