Mutual Fund FMPs and Liquid Mutual Funds best when Interest Rates Rise

The first talk of withdrawal of stimulus by the US Federal Reserve (central bank of the US) on May 22 this year marked the beginning of uncertainty in the Indian markets. Debt, equity, foreign exchange, none was spared as foreign institutional investors (FIIs) suddenly turned net sellers in the Indian markets. This was primarily due to US government bonds becoming more attractive as compared to debt and equity assets of emerging market economies like India.

To put it in perspective, FIIs have sold a total of $12.6 billion (Rs 75,326 crore) worth of securities from Indian debt market between May 22 and October 9. As a consequence, increased demand for dollar aggravated by speculation on rupee, led to it touching a record low of Rs 68.83 to a dollar on August 28.

In order to curb this speculation and support the Indian rupee, RBI came out with extraordinary measures to tighten liquidity. This led to a rise in short term rates by at least 200 basis points (100 basis points = 1 percentage point).

This led to volatility in the returns of the debt mutual fund schemes, which invest in these securities. Even the returns of liquid mutual funds, considered safest of all, turned negative.

Now what should an investor do in such a volatile scenario. Should one redeem at a loss? Or stay invested? If one stays invested for a longer period of time, one can ride over short-term volatility as extraordinary measures are for extraordinary situations and once the normalcy is attained they are unwound gradually.

In a rising rate scenario one should take advantage of higher short-term rates and invest in products such as liquid funds and fixed maturity plans (FMPs).

Investors must be aware that debt mutual fund categories such as short term plans, dynamic bond funds, income funds and gilt funds have inherent interest rate risks and as such they should be looked at only after aligning one's investment horizon and risk appetite, in consultation with one's financial advisor.

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