87% of short debt funds earn less than banks. Is it time to move to FDs?

In the last one year, 87% of the short term debt mutual fund schemes have delivered lower than the 4% interest rate bank savings accounts earn. Short term debt schemes include categories such as short duration, low duration, liquid funds, money market and overnight debt mutual funds. 13 of 165 schemes delivered lesser than 3% returns in a year. Given the abysmally low returns, is it better to keep the money in savings bank accounts or bank fixed deposits (FDs)? What lies ahead for short duration debt mutual funds? Here's all you want to know.

Blame decline in bond yields

Low duration debt funds on an average invest in assets with maturity of 1 and 1.5 years while short duration funds invest in maturity of up to 3 years. Over the last two years, explains Anitha Rangan, economist at Equirus, yields in the short-term segment have been low, driven by RBI's liquidity actions resulting in infusion of significantly high volumes of liquidity (~₹6 lakh crore-7 lakh crore). This has resulted in decline of yields in the shorter end of the yield curve more than the longer end of the curve.

To support the economy during the pandemic RBI had cut not just its repo rate (which is the base for lending rate) by 115 basis points from 5.15% to 4%. In fact, it has also cut the reverse repo (rate at which market participants can lend to RBI) by additional 40 bps, taking reverse repo to 3.35% (from 3.75%). "Driven by the excess liquidity, the operating rate de facto became the reverse repo rate, shifting the overall overnight curve and very short-term segment close to 3.35%. Accordingly, the entire yield curve saw a decline in yields," says Rangan.

The decline in yields in the short-term segment was more pronounced than the long-term segment, though. For instance, the 1-year G-sec rates moved from 5.3% in March 2020 to 3.6% by July 2020 (~170 bps) while the 10-year segment saw a movement from 6.3% to 5.8% (~50 bps decline). In the same period the 3-year G-sec spreads declined from 5.6% to 4.1% (150 bps).

Interest rate cycle at its bottom

Interest rate cycle is reversing and at the same time, appetite for credit is gradually picking up. Interest rate cycle has reached its bottom and with the increase in inflation, global rate actions, domestic yields are on the rise. We have already seen both 1-year and 10-year yields move up from their bottom by 100 bps.

Long term bond yields, says Pankaj Pathak, fund manager - Fixed Income, Quantum Mutual Fund, may remain range-bound around current levels or move up only marginally as we expect this rate hiking cycle to be much shallower with the RBI trying to keep the terminal repo rate closer to 5.0%-5.5%.

Pathak further explains that the long-term bond yields, though, face risks from the abrupt change in stance from central banks, India faces this risk from an increase in global crude oil prices. This would force the RBI to hike interest rates sharply and markets could face higher volatility.

"With the RBI hiking the policy repo rates and withdrawing its liquidity support to the market, money market rates should rise," says Pathak.

Bank FDs vs debt funds for higher returns

"Interest in bank accounts will not see a commensurate increase as banks are still flushed with deposits and overall liquidity and therefore do not need significant incremental deposits," says Anitha Rangan of Equirus. Banks are also sitting with excess SLR investments and to fund credit growth, they can easily sell their excess SLR which is another dampener to increase deposit rates. Therefore, concludes Rangan, while yields in short term debt funds may go up, bank deposits will unlikely see similar increase.

Thus, to beat the inflation or at least meet inflation, investors are better off in debt funds vs bank accounts. However investors should take stock of the credit weightage of the funds and invest in schemes which are commensurate with individual credit risk appetite.

From investors' perspective, Pathak suggests a combination of liquid to money market funds will benefit from the increase in interest rates in the coming months; along with an allocation to short term debt funds and/or dynamic bond funds with low credit, risks should remain as the core fixed income allocation.

"We suggest bond fund investors have a longer holding period to ride through any intermittent turbulence in the market," says Pathak.

As per a Morningstar India report, the short duration fund category has witnessed net outflows for the fourth-consecutive quarter in a row. The category saw net outflows of ₹4,264 crore in Q3 FY 2021-22. The total AUM of the category is down by 3% compared with the previous quarter and down 12% since the same period last year.