Invest in open-ended debt schemes as interest rates peaking

Open-ended funds are those that are available for subscription and redemption from the asset management company (AMC) throughout, ie, on an on-going basis. Liquid funds, short maturity bond funds, long maturity bond funds, etc, are examples of open-ended funds.

 

Close-ended fixed income funds come with a defined maturity date, are available for subscription only during the NFO period and there is no redemption with the AMC – these are listed at the stock exchanges. Fixed maturity plans (FMPs) are the most common close-ended debt funds.

 

The implications of investments in the two categories vary.

 

In a rising interest rate scenario (prices come down when yield levels are rising), a higher allocation to FMPs is likely to reduce interest rate risk. In an FMP, with every passing day, the residual maturity of the product comes down and, thereby, the adverse impact of yields moving up on the returns from the fund is that much lower.

 

On maturity of the fund, the residual maturity of instruments in the portfolio is nil, hence, there is no impact of interest rate movements in the market. In open-ended funds, the portfolio maturity is managed by the fund manager based on the views on yield movements in the market, and the mandate of the fund.

 

The adverse impact of yields moving up may be less on close-ended funds, but when yields are coming down (i.e. prices moving up), they cannot capture the benefit. On the same logic, open-ended funds provide better returns when yields are coming down and, therefore, in such situations it is better to have a higher allocation to open- ended funds.

 

In light of the above, it becomes important to fine tune the allocation between the two categories. Over the past couple of years, interest rates have been moving up and the FMP component of the fixed income allocation of investors has rightly been moving up. While FMPs have captured higher yield levels available in the market, it has also protected investors from the adverse mark-to-market impact of yields moving up. However, now we are close to the interest rates peaking out.

 

Rate hikes by the RBI are expected to pause soon. Somewhere down the line, may be between nine months and a year from now, interest rates are expected to ease as inflation becomes more bearable and the RBI shifts policy focus to growth of the economy.

 

Hence, the portfolio would benefit if, over the next three to six months starting from now, investors gradually increase the open-ended component of the fixed income portfolio to make it somewhat balanced between close and open-ended funds. As and when yield levels in the market come down, open-ended funds are likely to gain more in the mark-to-market component, thereby leading to better returns.

 

For example, let us assume a portfolio of 10 lakh where 5 lakh were in equities, 4 lakh were in FMPs and 1 lakh in short-term bond funds, ie, an 80:20 allocation to close and open-ended funds within fixed income. If over the next three to six months the allocation were revised to 2.5 lakh in FMPs and 2.5 lakh in a combination of short and long maturity bond funds, ie, approx 50:50 in close and open-ended funds within the fixed income category, the investment is likely to gain better from declining interest rates, as and when that happens.

 

FMPs may be used for laddering towards managing cash outflows and the open-ended bond funds would capture the market upside when yield levels come down. Long maturity bond funds would benefit more than short maturity funds, but the volatility risk of longer maturity would be that much higher.

Source: Economic Times