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How to take advantage of rising short-term interest rates
When the instrument matures after a month or two, or when the fund gets fresh subscriptions, that quantum is invested at the then prevailing yield levels.
Yield levels of short maturity debt instruments, also known as money market instruments, have moved up i.e. prices have come down. Liquidity in the banking system is not as much in surplus as earlier. The Reserve Bank of India has hiked repo rate on June 6 and more rate hikes are possible. When bond yields are moving up, returns on your existing investments will suffer as the mark-to-market will be adverse. That is, the valuation of your investments will be at a lower price. That being the case, what should you do? We look at the feasibility of the options.
We all know that liquid funds are evergreen, with performance stable in various market cycles. The maturity of instruments in the portfolio can be maximum 3 months as per rule, but practically, fund managers buy instruments of even lower maturity, say 1 or 2 months. For the valuation of the everyday portfolio, for the computation of daily net asset value (NAV), there is a valuation guideline for the maturity of more than 2 months. Hence for instruments with a maturity of fewer than 2 months, valuation for NAV is done at cost price, without considering the market movements. That day’s interest accrual is added to the NAV, which is one day’s return for the investor.
Floating rate instruments are ones where the coupon, instead of being fixed, varies along with a pre-defined parameter. For example, if the parameter is Mumbai Interbank Offered Rate plus 1 percent, then the coupon will be the average MIBOR rate for the coupon-payment period plus 1%. If rates are moving up e.g. if MIBOR is moving up, the investor gets the benefit. Conceptually, floating rate instruments, or floaters as they are popularly called, are not prevalent. In the mutual fund space, there is no floating rate fund in the real sense of the term e.g. a fund comprising 65 percent or more or floaters, due to this constraint. The so-called floating rate funds, if any, have a small component of floaters and the balance is invested in money market instruments where the interest gets re-set after a short period of time. However, interest reset happens in Liquid or Ultra Short Term Funds anyway.
The other option is short-rollover Interval Funds, say 3-month Interval Funds. Interval Funds are open ended funds, but there is no redemption with the AMC in the interim period. Redemption is available only in the specified transaction period (STP), which for a 3-month Interval Fund, is after every 3 months. As per rule, the fund manager can buy instruments of maturity up to the rollover period e.g. in a 3-month Interval Fund, the fund manager can buy instruments up to 3-month maturity. Hence the mark-to-market risk is limited to that extent, but the portfolio is re-constructed after the roll-over period at the then prevailing yields. If interest rates have moved up in the interim period, roll-over happens at higher yields.
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