Date with debt funds: Taking a tough call amid soaring inflation, rising policy rates

Investing your hard-earned money in fixed income space is a tough call, given the anticipation of higher interest rates going forward

June 14, 2022 / 01:27 PM IST
File photo

File photo

The Monetary policy committee (MPC) of the Reserve Bank of India (RBI) has decided to hike the repo rate by 50 basis points to 4.9 percent on Wednesday. The RBI has been vocal about rising inflation and its intentions to withdraw liquidity in the financial system. This should ensure that the bond yields will move up and the mutual fund schemes investing in bonds, too, will see some impact.

Here is how you should deal with your debt fund investments:

Inflation is the focus

The rising inflation in the economy has been a cause for concern for most market participants. The central banks worldwide has been raising interest rates, and the RBI too is expected to act in similar manner. The inflation expectations are above the current upper limit of 6 percent set by the RBI for the medium-term inflation.

“On the assumption of a normal monsoon in 2022 and average crude oil price (Indian basket) of $105 per barrel, inflation is now projected at 6.7 percent in 2022-23, with Q1 at 7.5 per cent, Q2 at 7.4 percent, Q3 at 6.2 percent, and Q4 at 5.8 percent, with risks evenly balanced,” mentioned the statement by the RBI Monetary Policy Committee. In April, the FY2022-2023 expectation was at 5.7 percent.

Inflation numbers are rising in many parts of the world and market participants do not expect inflation to taper down quickly. This view is visible in the bond yields. Over the last one year, the benchmark 10-year bond yield has moved to 7.45 percent from 6 percent. Rising bond yields pull down the debt fund returns. Over the last one year ended June 7, 2022, long-duration debt funds on the average lost 0.55 percent, whereas gilt funds gave only 0.1 percent returns, as per data from Value Research.

Bond yields to harden

“Another 50 basis point hike in next policy cannot be ruled out,” Rajeev Radhakrishnan, CIO-Fixed Income, SBI Mutual Fund, says. A front-loaded policy rate adjustment seems more likely rather than a long drawn-out rate adjustment process considering the domestic and external backdrop. "We expect the policy rate adjustment process to be completed over the fiscal year," he adds.

Put simply, the rates are going to go up significantly from here. Sandeep Bagla, CEO, Trust Mutual Fund does not expect inflationary expectations to come down. “The repo rate needs to go up to 6-6.25 percent to effectively contain inflation,” he says.

Given the low interest over last couple of years, the investors may find the current yields attractive. However, experts warn that the yields may harden further. “The 10-year benchmark bond yield may trade at 8-8.25 percent and repo rate may be at 5.75-6 percent by March 2023,” says Vikram Dalal, Founder and Managing director, Synergee Capital Services.

What should you do?

Investing your hard-earned money in fixed income space is a tough call, given the anticipation of higher interest rates going forward. Though the bond yield on 10-year benchmark bond has remained soft today, long-term bonds are best avoided given the expectations of higher bond yields in near future. Long duration funds and gilt funds investing in long-term government securities should be avoided.

“Short-term debt funds investing in bonds maturing in two to three years are a good investment option at this moment as the yields have gone up factoring in the expectations for higher interest rates,” says Bagla.

Short duration funds as a category has given 5.81 percent returns over last three years. Investors should also take a look at the quality of the bond portfolios of these schemes and choose those with high quality bonds and sound track record.

For investors keen to hold on to their investments for a bit longer timeframe, select target maturity funds can be an alternative. Nitin Shanbhag, Head of Investment Products, Motilal Oswal Private Wealth says, “The yield curve is quite steep and is likely to continue to flatten going forward. The prevailing term spread between the 10 year and 5 year yield is not attractive relative to historical spreads. Hence, for Fixed Income portfolios, we suggest core allocation to the 4-5-year maturity segment in high credit quality, target maturity debt funds which invest in a combination of government securities, state development loans, and AAA-rated instruments.”

Earlier this year, some investors were seen chasing bonds rated AA and lower for high yields they were offering compared to their AAA-rated counterparts. But the rising interest rate regime may call for a rethink of this strategy, given the changing risk-reward.

“Low-rated bonds are best avoided for two reasons. Some of the issuers of these bonds may find it difficult to refinance their loans as the interest rates go up. Also the increased yields on government bonds and good quality corporate bonds make them an attractive investment at this moment compared to low rated bonds,” Dalal says.

Investors should also avoid credit risk funds and focus on debt funds offering exposure to good quality bonds maturing in up to three years. These will ensure that the default risks are minimised and the investors also get to participate in higher yields.

Investors keen on investing in long term-bonds for locking in the yields, should wait for the yields to move up.
Nikhil Walavalkar
first published: Jun 8, 2022 01:01 pm