Should you sell out your fixed income portfolio

On July 15, 2013 the RBI had made borrowing costly by capping borrowing of funds by banks as part of repurchase agreements to Rs 75,000 crores. Any additional borrowing over the LAF limit is at a higher interest rate called the Marginal Standing Facility (MSF) rate. This too has been increased by 2% to 10.25%. The RBI has also hiked the bank rate – the discounted rate at which the RBI lends to banks – by 2%.When these measures could not adequately arrest the fall in the rupee , on 24th July the RBI resorted to further tightening, by asking the banks to maintain a minimum 3.96% of deposits as reserves every day. The RBI in its two step progressive measures clearly signaled that it was ready to sacrifice growth at the edifice of the rupee.

How variation in interest rates affects debt funds returns.

In a sharp reaction, although the measures were announced as temporary and at the shorter end of the yield curve, the bond prices reacted negatively with the benchmark 10 year Gsec recording a high of  8.44% on July 24, 2013 as it was perceived by the players as a change in policy. The FIIs have sold debt worth  Rs 12081/- in July.  The dynamic changes in the market have led to sharp losses across all debt funds. Typically, a debt fund has two flows – the daily accruals and the mark to market (MTM) gains or losses. While most of the time the accruals can cover the short term losses in a debt fund, a sharp change to the MTM can result in a massive hit to the NAV.

Let me explain with an example: Say a debt fund is having a portfolio of securities earning 9 % p.a. This loosely translates to about 3 p per day. On July 16, 2013, the day after RBI announced the tightening, the 10 year Gsec price lost Rs 3.50 thus effectively negating accruals of about 116 days just in one day. However the actual impact would largely depend on the duration of the fund. The shorter tenor funds would be less impacted as against those with longer duration. Thus debt funds across the board had to report falling NAVs creating a panic situation amongst mutual fund investors. Should one redeem, should one hold or should one in fact look at this as an opportunity to invest further funds?

Way forward

One of the fall out of the depreciating rupee could result in India rating downgrade. Considering the prospect for the rupee, RBI is likely to hold or hike interest rates. This is expected to hurt corporate plans for any expansion. Besides increasing the borrowing cost for businesses, it also affects revenue and profit growth. Equity markets are unlikely to witness significant gains in such a situation. Yet, it must be noted that although FIIs have been net sellers all of June and July in both debt and equity, the equity markets have not really crashed in tandem.

The commodity markets too did not bear the brunt of falling global prices as the rupee depreciation, indirectly insulated them. 

In response to the RBI measures the rupee did appreciate to 59.13, signaling that the volatility has been stemmed. However the real impact could be seen in the forthcoming weeks. RBI’s rupee tightening will have to be followed up with tangible measures to shore up forex reserves e.g. a forex-denominated offshore bond issuance. As the rupee appreciates to 58.80 levels, exporters would also like to unwind their dollar positions. Clearly the comfort would be at 57 levels.

So investors who are already invested in the market, would be better off in continuing to hold as the daily accruals will keep offsetting the MTM losses. For others, it is indeed an opportunity to invest as the yields are truly attractive and may not stay for too long e.g. the benchmark 10 year Gsec is already trading @ 8.15 % as on 26th July 2013, as against a close of 8.41% on 24th July 2013.

Often when markets correct sharply, it is expected that they will continue to fall for some more time as it takes time for structural changes to manifest themselves. So it will be wise for investors to invest in tranches because markets are known to peak out quickly and sharply, without notice.

- Anagha Hunnurkar
(The author is an investment professional from Mumbai. She is working as a Senior consultant in the area of wealth management and corporate advisory services.)