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.

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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.

Liquid funds

We all know that liquid funds are evergreen, with performance stable in various market cycles. What is it about liquid funds that make it so stable in performance? 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 valuation of everyday portfolio, for computation of daily net asset value (NAV), there is a valuation guideline for maturity of more than 2 months. Hence for instruments with maturity less 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.

What is happening effectively is that the market volatilities, either positive or negative, are being ignored and only the pro-rated interest accrual for the day is the return for investors. 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.

In the meanwhile, if yields have moved up (i.e. prices come down), then the fund gets the benefit and the daily accrual level moves up to that extent. Hence without suffering the adverse mark-to-market impact, the fund gets the benefit of rising yields. However, the reverse is also true when yields are easing.

Floating rate

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%, 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% 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.

Interval Funds

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.

Other fund options

Beyond liquid funds, which have portfolio maturity up to 3 months, there are ultra short duration funds with portfolio maturity in the range of 3 to 6 months and Low Duration Funds in the range of 6 to 12 months. Currently, money market yields being elevated, if you enter ultra short or low duration or money market funds (maturity 1 day to 1 year), you will stand to benefit. The ‘carry’ of the portfolio, which is the daily accrual level, is that much higher and as and when the instruments in the portfolio mature, it will be reinvested at a higher yield. In this context, higher yield implies higher than liquid funds, since there is a limitation of less than 3 months in liquid funds. However, to be borne in mind, there is mark-to-market in non-liquid funds i.e. ultra short/low duration/money market funds. The significance is, during your holding period, if yields come down (i.e. prices move up) you will earn more than the accrual. If unfortunately yields move up (i.e. prices come down) your returns will be impacted to that extent.

If you want to benefit from elevated money market yields but play safe, with minimal mark-to-market impact, then liquid funds are advisable. There is a fund category called Overnight Fund investing only in overnight securities with maturity of 1 day, but the fund options are limited, with only a few AMCs offering it.