There is no mistaking the tension every time there is talk of the domestic interest rate scenario. Interest rates are on a surge; the 10-Yr, 7.59% Government of India (GOI) paper was trading at a yield of 8.12% (June 28, 2006). Interest rates are unlikely to go down anytime soon, at least that is the indication at this point in time. So debt fund investors need to have a pretty resilient strategy if they want to preserve their capital effectively. We have outlined the 3 biggest allies in the mutual fund segment to help investors counter higher interest rates.

1. Liquid funds
Liquid funds are an uncertain investor’s biggest ally. Whether the investor is uncertain with regards to the interest rate scenario or uncertain about what he wants to do with his money is immaterial; liquid funds are an answer to both these uncertainties. Liquid funds are ideal for investors who have a very short investment time frame, as short as a day. So you can invest your money in a liquid fund till such a time that the uncertainty (with regards to interest rates in this case) is dispelled.

Since liquid funds usually have very similar portfolios (consisting of money market instruments and call money), there is not much product differentiation over there. However, given that liquid fund returns are wafer-thin, it is imperative to select the ones with the lowest expense ratios.
 

• To find the best liquid funds, click here!
   

  2. Short-term debt funds
  Another fund that fits the bill for an uncertain investor’s portfolio is the short-term debt fund. While liquid funds do the job of insulating the investor’s portfolio from high interest rates well enough, short-term debt funds do it as well and can even give a slightly higher return. The difference between a liquid fund and a short-term debt fund is the investment tenure. Liquid funds are ideal for investors with an investment tenure ranging from 1 day to 30 days. While investors can remain invested in liquid funds for longer than that, the return may begin to look a little unattractive compared to the next product on the maturity parameter i.e. short-term debt funds
   

• To compare short-term debt funds with liquid funds, click here!
   

  Like liquid funds, short-term debt funds are predominantly invested in low-risk debt instruments (both from interest rate as well as credit risk perspectives) like short-term corporate debt, money market instruments, call money. Only difference is that short-term debt funds can invest in slightly longer dated paper. That makes them ideal for investors with investment tenure in the 30 days – 90 days range. So if investors have an investment tenure of more than 30 days, they should typically be investing in short-term debt funds as opposed to liquid funds.

  Investors must note that the short-term debt fund category is quite varied; you have short-term debt funds, short-debt floating rate funds, short-term gilt/gsec (government securities) funds. We recommend that investors select short-term debt funds and short-term floating rate funds. Again, keep an eye on the most inexpensive funds.

  3. Floating rate funds
  This is the only long-term debt fund we would recommend investors to consider in a rising interest rate scenario. This is mainly due to the fact that floating rate funds are better geared to take on rising interest rates. Floating rate funds invest in debt instruments that have their coupon rates linked to a reference/benchmark like the MIBOR (Mumbai Interbank Offered Rate) for instance. The MIBOR is a good barometer of the prevailing interest rate scenario in the country. The coupon rate on the debt paper is revised regularly in line with changes in the MIBOR. So at the end of the day, the floating rate debt instrument (and the floating rate debt fund) captures the interest rate mood fairly well, at least a lot more effectively than the fixed rate debt instrument.

  Floating rate funds are ideal for investors with an investment tenure of at least 12 months. Again there is little to choose from within floating rate funds since they invest largely in floating rate paper, which is usually rated highly (in terms of credit-worthiness) and carries lower interest rate risk since coupon rate is revised periodically. So the investor has to keep a tab on the expense ratios of these funds while making a selection, because this can make a significant difference to your returns over a 12-month period.

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