Aparna asks, “Dear Sir, short term fixed deposit interest rates have started to increase. Can you please write an article on which type of mutual funds we can invest in to benefit from interest rate increase?”
Since May 2020, the Repo Rate has remained constant at 4%. So this has many observers jumpy and expecting a rate hike in 2022. The FD rate hike has only been marginal, probably reflecting a higher credit demand and higher inflation.
Assuming that the RBI increases the Repo Rate in the next few months, there will be a marginal increase in the coupon rate of short term bonds and the money market.
Thus overnight funds, liquid funds, money market funds and ultra short term funds will see a marginal improvement in returns. How medium-term and long-term bonds react cannot be easily predicted.
Some expect the NAV of debt funds holding such bonds to fall, and some (e.g. Parag Parikh Conservative Hybrid Fund) believe that the market demand and supply forces have already priced in a rate increase.
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However, an increase in the repo rate does not immediately mean the rate cycle has reversed. Future RBI decisions will depend on prevailing economic conditions then.
Also increase in interest rates is a harmful development for investors! This typically means that inflation is also higher, and lesser money is available for saving.
What should investors do? We recommend building a debt portfolio that is a mixture of security, reasonable risk and efficient taxation. With respect to debt mutual funds, we recommend using liquid funds or money market funds for needs 5-7 years away. Arbitrage funds can also be used as a tax-efficient alternative. Fund recommendations are available here: Handpicked List of Mutual Funds Jan-Mar 2022 (PlumbLine)
Target maturity funds can also be used under certain circumstances.
However, investors should not get fixated on a return number with any debt fund. Once you put money in it, the returns are entirely uncertain and unknown. Unless we take this attitude, we may be in for some shocks in the investment journey.
For long term goals, we recommend using a mixture of safety and reasonable risk. For example, PPF + gilt funds or EPF + gilt funds or money market + gilts funds.
How about ultra short term funds? They can be used by those who can stomach some credit risk and associated credit events.
How about floating rate funds? These are complex products with too many uncertainties operating in a market area with huge supply-demand mismatches. So they are best avoided. We have earlier shown that short-term funds like overnight funds, liquid funds and money market funds will get the job done if the rates move up: Should we invest in floating-rate MFs to benefit from interest rate hike?