Consider money market funds in rising rate scenario

The portfolio is reinvested every year, so its yield resets to higher levels as interest rates rise

Mirae Asset Mutual Fund’s recently completed new fund offer for a money market fund (MMF) has brought this category into focus. At present, there are 18 funds with cumulative assets under management (AUM) of ~1,22,632.3 crore. MMFS are well suited for the current environment, where interest rates could harden.

Low-risk category

These schemes invest in instruments like treasury bills, commercial papers, and certificates of deposit, which have a maturity of up to one year. Most schemes in this category avoid taking any credit risk.

According to the June portfolio, almost all funds have 100 per cent exposure to ‘Aaa’-rated papers. “MMFS are one of the safest debt categories,” says Arun Kumar, head of research, Fundsindia.com. According to the Securities and Exchange Board of India's (Sebi's) definition, MMFs can invest in instruments with a maturity of up to one year. Therefore, they carry low interest-rate risk. Since their investment mandate specifies the maturity of individual securities (and not the average duration of the entire portfolio), fund managers do not have leeway in choosing the maturity profile of bonds. (They can’t adopt the barbell strategy, meaning they can’t have some bonds of much higher duration and some of much lower duration.) This eliminates the risk that they may invest in longer-dated bonds, which other debt funds carry.

“MMFS are ideal for storing money for a short period of time or money on which you don’t want to take any risk,” says Harsh Jain, co-founder and chief operating officer, Groww.

MMFS are also more liquid than fixed deposits (FDS). “Investing in them means you can withdraw money without any cost, unlike FDS, where you have to pay a penalty,” says Jain.

Low returns, faster reset

With inflation on the higher side (July consumer price index-based inflation came in at 5.59 per cent after printing above 6 per cent for several months), there is an expectation that interest rates may rise. Since MMFS invest in bonds that have a maturity of less than one year, the entire portfolio gets reinvested each year. Hence, investors stand to gain from rising rates. “We expect interest rates to inch up gradually over the next 12-18 months. MMFS, due to their lower modified duration, are less volatile when yields increase and quickly reset to higher yields, which improves future returns,” says Kumar.

They have a yield-to-maturity of 3.8 per cent at present, according to Value Research. After adjusting for an average expense ratio of around 50 basis points, the return stands at 3.3 per cent. This may look unattractive compared to returns offered on one-year and threeyear FDS (State Bank of India offers 5 per cent and 5.3 per cent, respectively).

“As the funds cannot invest in papers with maturity above one year, over longer periods MMFS offer lower returns than short-term funds or corporate bond funds, which have a higher average duration of one-three years,” says Kumar. However, as interest rates inch up, market forces will push up their yields faster than the rise in bank FD rates.

Tax implications

Capital gains on units held for more than three years are taxed at 20 per cent after indexation, making them more tax efficient than FDS. If the units are held for up to three years, the gains are added to annual income and taxed at slab rate.

Right fit

MMFS are a good option for the current environment. “They are expected to provide a good balance between nearterm volatility and returns over the next 6-18 months,” says Kumar. On fund selection, Jain says: “First, select a few consistent performers, then filter on the basis of expense ratio,” says Jain. The average expense ratio of regular plans is 54 basis points, while that of direct plans is 21 basis points.