How should debt fund investors play the RBI rate hike?

The Reserve Bank of India's Monetary Policy Committee (MPC) has continued with its rate hiking spree as it increased the policy repo rate by 35 basis points to 6.25 percent. The increase, in line with analyst views, has also raised expectations of the interest rate hiking cycle coming to an end soon. Against this backdrop, the investment strategies for debt investors need to be carefully reviewed. Here is what experts have to say.

Have the rates peaked?

If you have been investing in any fixed-income product that offers a market-determined rate of return, then this is the most worrying part of the investment puzzle. In most of the key economies, including the US, interest rates have been hiked by central bankers. Since May 2022, the RBI too has increased policy rates by 190 basis points to contain inflation. Hence, today's 35 basis-point rate hike is no surprise and was moreover discounted by the market participants. Though some investors have started to believe that we are nearing the end of the rate hike curve, do not make the mistake to think that rates will soon start coming down.

The quantum and pace of further rate hikes will be dependent on how the macroeconomic environment will shape up. “Headline inflation is expected to remain above or close to the upper threshold in Q3 and Q4:2022-23. It is likely to moderate in H1:2023-24 but will still remain well above the target. Meanwhile, economic activity has held up well and is expected to be resilient, supported by domestic demand. Net exports would remain subdued due to the drag from evolving external demand conditions. Further, the impact of monetary policy measures undertaken needs to be watched,” states the monetary policy statement issued today.

Simply put, investors have to keep a track of macroeconomic factors, both domestic as well as global, to get an idea of where the interest rates are headed. The Union Budget 2023 will also be a key event that will offer much-needed information pertaining to fiscal deficit and government borrowings.

Sandeep Bagla, CEO, Trust Mutual Fund says, “Unless there are negative surprises on the crude oil front, the RBI policy rates could be raised by another 25 to 50 basis points over the next three to four months.”

Though Raj Mehta, Fund Manager, PPFAS Mutual Fund expects the RBI to pause after this hike or probably pause after one more small hike, he rules out the chance of interest rates starting to reduce immediately. “Given the commentary from RBI regarding the inflation remaining high for the next year or so, we do not expect interest rates to start reducing immediately. We may go through a period of a stagnant interest rate scenario in the near future,” he said.

Will debt funds do well?

Debt funds over the last 18 months have seen a significant amount of volatility. Gilt funds have been under pressure since the interest rates started climbing. The 10-year benchmark bond yield rose to a high of 7.61 percent on June 16, 2022, from a low of 5.85 percent on January 5, 2021. It quotes at 7.3 percent today. According to Value Research, gilt funds gave 1.94 percent returns in one year ended December 6, 2022. Liquid funds that invest in very short papers gave 4.52 percent returns over the same tenure.

Going forward, investors may continue to make decent returns in the short-term oriented mutual funds, given the expectations that the rates may not be in a hurry to come down. However, smart investors may look at this as an opportunity to enter long-duration products. Elevated yields offered by these products can be attractive. For example, gilt funds on average had a yield to maturity of 7.17 percent as on October 31, 2022.

What should you do?

Bagla of Trust MF recommends investing around half of the capital in funds with maturity lower than two years as the interest income is likely to be close to 7 percent. “From the balance, 25 percent could be invested in banking, PSU debt funds, short-term funds or corporate bond funds, where there is some possibility of higher returns over the medium term,” he said. For the remaining 25 percent he asks investors to consider gilt funds, which could benefit from any positive surprises on the inflation front.

Deepak Panjwani, Head-Debt Markets, GEPL Capital advises investors to continue investing in short-duration funds. “We are seeing a flat yield curve in the 15 to 40 years segment. And compared to that, shorter durations are more attractive,” he says.

The expectation of the interest rate cycle peaking can be a good entry point into long-duration products including gilt funds. Vikram Dalal, Founder and Managing Director, Synergee Capital Services says, “Investments in long-term gilt funds can be considered in a staggered manner as the clarity emerges on interest rate movements. Though the current short-term yields are attractive, it is better to lock yields available on medium- to long-term bonds. Aggressive investors can consider investments in gilt funds or dynamic bond funds with higher duration in a staggered manner.”

Target maturity funds and units of Bharat Bond ETF can be considered by investors who are conservative in nature and want to remain invested for the long haul. These products invest in good quality bonds and offer visibility of returns if the investor is prepared to hold on to the investment till maturity. “Investors buying into target maturity funds when the interest rates are high tend to benefit in roll-down maturity portfolios offered. These schemes can give higher returns along with the additional benefit of indexation if held for more than three years,” Panjwani said.

Investments in gilt funds or long-duration funds should be done with a minimum three-year view. It also helps in earning better tax-efficient returns as a concessional rate of tax – 20 percent on long-term capital gains with indexation benefit kicking in.

Though investors may find themselves in a sweet spot in both short-term as well as long-term duration debt funds, interest rate risk should not be ignored. If the macroeconomic situation worsens and inflation rises, yields may spike too. A quick move-up in yields may lead to marked-to-market losses for mutual fund investors. Ideally, investors should match their holding period with the duration of the scheme they are keen to invest.