Debt mutual funds have been witnessing high volatility for some time now. The volatility comes from changes in the interest rate cycle. The Reserve Bank Of India has already raised the interest rate for the third time this year to bring the repo rate to 5.40% in August. It is expected to increase interest rates further. How much will the interest rates rise? Should you invest in accrual or duration funds at this time? Which funds will give higher returns to investors?

RBI would want to take interest rates to neutral territory, says Manish Banthia, Senior Fund Manager, Fixed Income, ICICI Pru AMC, which means that since the inflation is around 6% on the forward looking basis, RBI would want to take interest rates to that zone. "We are in the cycle where the RBI will take rates to possibly over neutral since the macros are pointing to a very high trade deficit, inflation is also ahead of the RBI’s comfort zone. We expect the repo rate to go to 6% and slightly above that in fact," he says.

Banthia explains, once you move out of the recovery phase to expansion phase when the confidence is back in the economy, corporate earnings start to improve, general capacity utilisations improve and credit growth also starts to improve and the RBI then wants to take policy rate to neutral as the inflation also starts to move up. This is the phase we have seen in the last six months.

From an investor's perspective, Manish Banthia believes there is no point in adding duration to the portfolio. "Investors should not take unnecessary duration risk. They should remain at the short end of the curve. As the liquidity tightens and credit growth improves, the accrual part will start to deliver much higher Yield to maturity( YTMs)," he says.

"Investors should look at fund categories such as short duration funds and funds with floating rate kind of strategies. Do not buy long duration strategies at this point of time," he adds.

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