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Interest rates are on the rise, which debt instruments should you choose?

A vegetable seller counts Indian rupee notes in Mumbai (AFP)

As we know bond prices and yields move in opposite direction. When one rises, the other declines.

Although the era of rising interest rates is not considered an ideal time for debt investors, particularly long-term debt instruments, investors can explore short term debt.

Ultra-short or floating rate

Experts, consequently, say that investors can invest in ultra-short debt funds and floating-rate debt funds as of now.

For the uninitiated, ultra-short debt funds tend to invest in Government of India treasury bills, commercial paper issued by corporates and certificates of deposit issued by banks. When interest rates rise, the instruments they own mature and are replaced by the ones with higher yields.

Among ultra-short debt funds, it is advisable to invest in the ones that allocate more to safer avenues such as treasury bills and certificates of deposit.

Ankur Kapur, Managing Director, of Plutus Capital, advices investors to invest in safe short-term debt. “If you want to park your funds, a floater rate fund or a liquid fund will give you a similar return. However, if you do not have any specific need but want to allocate into debt from an asset allocation point of view, a safe short-term debt may be preferred," says Mr Kapur.

Sandeep Bagla, CEO of Trust Mutual Fund also echoes the same sentiment when he says, “A short-term fund with maturity of 1-2 year is an ideal fund for making investments. There are funds with roll down strategy which have high yield but low interest rate risk."

Lower incentive to invest

One of the key disincentives to invest in rising interest rate cycle is the fact that bond prices keep declining along with a proportionate increase in interest rates.

“It is difficult to invest in rate rising cycle. As interest rates rise, prices of bonds keep sliding. While bonds accrue interest income, the returns to investor are lower due to the depreciating prices. Lower returns from the debt funds discourage investors," Bagla adds.

He also says that most interest rate cycles tend to reverse over a few quarters. “Most cycles nowadays are not very extended and tend to reverse over a few quarters. A simple strategy of investing across the rate cycle in select funds would augur well for the investor, allowing him/her to earn rising rates of interest without excessive volatility in fund values," says he.