Status quo on rates: Stay put with shorter-tenure debt funds

The Reserve Bank of India (RBI) has kept policy rates unchanged in its monetary policy announced earlier today. In keeping with this status quo, debt fund investors too may retain their holdings in these schemes.

Interest rates can still decrease

Although the RBI kept the repo rate (4 percent) and the reverse repo rate (3.35 percent) unchanged, governor Shaktikanta Das said that the monetary policy committee’s stance is ‘accommodative.’ Thus, the RBI is open to making reductions in interest rates later, if found necessary for reviving growth and overcoming the impact of COVID-19 on the Indian economy. When interest rates fall, prices of bonds – and therefore the net asset values of debt funds invested in them – rise. So far, the RBI has reduced policy rates by 250 basis points since February 2019 and Das added in his statement that rate cuts have been working, in the sense that transmission of lower interest rates have happened thanks largely to liquidity conditions it induced, despite banks remaining averse to lending. When interest rates are kept unchanged with the possibility a decline later, it’s best to stick to your debt funds.

“The RBI has to worry about the depositor, the silent saver, and hence needs to be careful and calibrated in rate cuts,” says Pankaj Pathak, Fund Manager-Fixed Income, Quantum Mutual Fund.

Frothy equity markets

Equity markets have been extremely volatile so far this year. The S&P BSE Sensex fell by 37 percent, from a high of 41516 on February 12 to a low of 25981 on March 23. Subsequently, the Sensex rose to 38493, giving a gain of 48 percent. In his policy speech, Das sounded cautious about the rise in the global financial markets. “A renewed surge in COVID-19 infections in major economies in July (2020) has subdued some early signs of revival that had appeared in May and June. Global financial markets, however, have been buoyant, with the return of risk-off sentiment inserting a disconnect from the underlying state of the real economy.”

“When equity markets seem over-valued, it’s all the more important to have a section of your portfolio in debt funds to ensure stability, should equity markets correct. There is a disconnect, as Das pointed out, between the real economy and equity markets,” says Vikram Dalal, founder and managing director, Synergee Capital Services.

Re-structuring of assets

The RBI has provided room for banks to restructure the debt of companies under stress due to the COVID-19 pandemic. Credit risk funds and a few others have invested in some of these companies and face the possibility of a default.

Such restructuring may help debt funds if their underlying investments benefit from the arrangement. Experts suggest sticking to debt funds that come with good quality assets. Vikram suggests Banking & PSU debt funds, “as they invest mainly in bonds issued by government-owned companies.”

A small benefit can also accrue to those funds that hold bonds issued by gold-loan companies as RBI has increased the loan-to-value ratio for loans pledged against gold ornaments. This would boost gold loan companies. But if gold prices were to fall, which seem unlikely in the near future, gold-loan companies may face the heat.

Boost to corporate bond markets

The RBI also allowed banks to set aside capital for their investments in debt mutual funds (MF) and debt exchange-traded funds (ETF), in line with what they are required to, when they invest directly in corporate bonds. Detailed guidelines on this will be readied by the RBI, but here’s what it means.

When banks invest in corporate bonds or any market-linked instruments such as equities and mutual funds, they have to set aside certain amount of capital. Till now, the capital to be set aside for investments in corporate bonds depended on the credit rating, whereas for equities and mutual funds (MF), it used to be far higher. Now, the risk capital charge to be applied for a bank’s investments in debt MF and debt ETFs will depend on the credit rating profile of the fund’s underlying investments. If a debt fund, for instance, invests 80 percent in AAA-rated securities and the rest in AA-rated instruments, the risk weightage will be applied appropriately.

This move has the potential to boost the corporate bond market. Typically, banks withdraw from debt funds to maintain their month-end risk-weighted capital requirement and re-enter MFs again at the start of the month. “As a result, fund managers would buy only liquid securities and not corporate bonds because money flows in and out. Now, because bank money will be more stable, we can invest more in corporate bonds,” says Marzban Irani, Chief Investment Officer-Fixed Income, LIC Mutual Fund.

What should you do?

Stay invested in shorter-tenure and Banking & PSU debt funds. Avoid investing in longer-tenure funds. Ensure that your debt fund’s portfolio quality is good. Do not take credit risk.