Visualising how interest rate movements affect debt fund yields

I have been thinking a lot about the debt part of my mutual fund portfolio. Because I follow Kuvera’s recommendations, I started off with a liquid fund as recommended by Kuvera. But I am always trying to find a debt fund that provides better returns without compromising too much on stability. I don’t want to invest in AA or lesser quality debt; I don’t want to invest in debts with longer durations such as 3 years or 5 years; I don’t want those risks. I want the volatility to be pretty much nonexistent while providing a better return than liquid funds. (Let’s keep aside the discussion of whether I should look beyond liquid funds at all.)

My natural first move was to look at Ultra Short Term (UST) debt funds. After looking at the portfolios and past performances of a few UST funds, I picked 2 funds for my portfolio. Though they have been my only debt instruments for many months, my fascination with debt funds is unceasing. I keep looking at other fund categories (such as Short Duration funds, Conservative Hybrid funds, etc) and considering if they are better than the UST category. It’s hard to tell just by looking at few months’ fact sheets and recent returns.

My confusion has increased due to the low bond yields for close to a year now. Liquid funds that used to give 6% returns are down to 3%; UST funds that used to give 8% are giving only around 4%. Other fund categories, such as corporate debt funds and short duration funds seem to be doing well even after the interest rate was reduced. Should I be switching to some other debt category? Maybe I should temporarily switch to a different category until the interest rates go up again? So many questions, but no easy answers anywhere. ValueResearch provides some insights into the risk and return characteristics of funds, but even that seems insufficient to tell whether it’s a good idea to move away from the UST category.

This is when I discovered the usefulness of historical rolling returns. The graph below is particularly insightful (graph screenshot taken from RupeeVest.com) and gave me the answer I was looking for.

Historical 1 year rolling returns of an Ultra Short Term debt fund and a Short Duration debt fund (click to enlarge)

The most interesting part for me from this graph is how the trajectory of the 2 lines are often in opposite directions. In 2009, the UST fund’s yield has started to go down and begins to go back up by late 2010 before getting back to older levels in 2012. How did the Short Term (ST) fund do during this time? The ST fund’s yield shot up when the UST fund’s yield went down; when the UST fund started recovering, the ST fund fell! Eventually, in 2012, both funds have caught up. The rise and fall of the UST fund is much smoother than the ST fund’s sharp rise and fall.

I think this is the key to understanding how these funds react to changing interest rates: UST yields go down quickly and recover quickly when the market interest rate changes. ST fund has a period where it enjoys higher yield when rates go down (due to the longer duration of the debts it holds), but suffers a fall on the other side when the market rates go up again (again, due to the longer duration of the underlying debts).

Look at the extreme right end of the graph: UST yield keeps on going down but the ST yield is staying above with 3+ percentage points better return. (In fact, this difference was the reason I even considered the ST category!) Eventually the interest rate will go up and when it does, the ST fund’s value will drop. The worst thing one can do is to buy an ST fund today because the returns are better: you’ll be paying more than the underlying debts’ actual yield (thanks to mark to market adjustment) and when the interest rate goes up, you will end up losing money.

If the debt fund that you chose for your portfolio is an ST fund, I guess you can continue to invest in it. Your existing portfolio would have gone up now. Your returns will average out when your ST fund’s value goes down later. But entering an ST fund today just to benefit from recent higher yields is a loss making move.

If you are willing to play tactically and buy/sell based on interest rate movements, you can very well do that and capitalise on the prices going up. But tactical play really is not my thing, so I should just stick to my UST funds.

I started this enquiry with the question of whether I can do something to increase the yield of my debt investments (without taking too much risk). The answer is clear: I just have to accept low yields for the time being. Looks like there is no prudent way to make my debt portfolio give a better yield.