Mumbai: Investors could mount their bets on debt schemes that invest in short-term bonds as tightening liquidity is expected to boost returns on these products. Fund managers are recommending ultra short-term debt schemes, which could return over 6.5% or more if the Reserve Bank of India raises interest rates further.

Liquidity in the banking system has slipped into deficit for the first time in three years. Shrinking liquidity and a pick-up in credit demand are expected to result in short-term interest rates firming up.

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“The days of easy liquidity are over. Short-term rates are moving up and could remain elevated for some time,” says Sandeep Bagla, CEO, Trust Mutual Fund.

Retail credit offtake has been robust and loan demand from corporates has started picking up, which has reduced liquidity in the system and pushed up short-term rates, said Dwijendra Srivastava, CIO (Debt), Sundaram Mutual Fund.

Fund managers said, in this situation ultra short-term funds are the best bet as there are low chances of suffering mark-to-market losses. This category of funds invest in debt and money market instruments where the duration of the portfolio is between three and six months. In case of rate hikes, the chance of a mark-to-market loss is low as compared to long-tenure funds.

Ultra short-term funds could fetch over 200 basis points more than comparable deposits by banks, which have been slow in hiking rates. For instance, short-tenure bank deposits of say six months fetch pre-tax returns of 4.5-4.65%.

When rates go up, long tenure bond prices are hit the most, and products that invest in such papers suffer mark-to-market loss. At this juncture, when there is still uncertainty on when interest rates would peak, investors would be better off with ultra short-term funds.

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Fund managers believe the rate hike exercise globally is not over as the Fed looks to contain inflation.

With this level of hawkishness from the Fed, it would be extremely difficult for the RBI to soften its tone on the domestic monetary policy anytime soon,” said Pankaj Pathak, Fund Manager (Fixed Income), Quantum Mutual Fund.

Fund managers believe even in India, the RBI would have to hike rates in line with global peers. “To attract foreign capital and be competitive, you need to raise rates else your current account deficit will be high and the rupee will slip.