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What should debt fund investors do as RBI hikes repo rate?

RBI has raised repo rate by 25 basis points on February 8. This pushed up the short term rates. Here is how investors should realign their debt fund investments.

February 10, 2023 / 09:27 AM IST
RBI Monetary Policy

RBI Monetary Policy

Interest rates are peaking, as is the mood on bond street. Though the monetary policy committee of the Reserve Bank of India (RBI) decided to go with a 25-basis-point hike in the repo rate on February 8, the experts are vocal that the central bank is close to the peak in interest rates this cycle.

Here’s how you can tweak your bond fund investments:

Repo rate hike and growth

The RBI announced a hike of 25 basis points in the repo rate on February 8, as envisaged by many experts earlier. The move is aimed at containing inflationary pressures in the economy, with a high-interest-rate regime. The MPC has taken note of the moderation in headline consumer inflation numbers in recent times. However, it highlighted various risks that may keep inflation elevated, including global commodity prices.

“On the assumption of a normal monsoon, CPI inflation is projected at 5.3 percent for 2023-24, with Q1 at 5.0 percent, Q2 at 5.4 percent, Q3 at 5.4 percent and Q4 at 5.6 per cent,” said Shaktikanta Das, Governor, Reserve Bank of India.

Compared to the December MPC review, the RBI has maintained its inflation projections for the first two quarters of the next financial year and released projections for the remaining two.

Mahendra Jajoo, CIO-Fixed Income, Mirae Asset Investment Managers, said, “While there is a marginal reduction in the near-term inflation projection, the FY24 inflation estimate still remains well above 5 percent. Thus, the guidance continues to be one of continued vigil and caution. A marginal upgrade in the growth forecast bodes well on the economy front.” He expects further moderation in inflation numbers going by incoming data.

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In the December policy review, real GDP growth was projected at 7.1 per cent for Q1 of 2023-24 and at 5.9 per cent for Q2. However, the projections have been tweaked upwards by the MPC now. “Real GDP growth for 2023-24 is projected at 6.4 per cent, with Q1 at 7.8 per cent, Q2 at 6.2 per cent, Q3 at 6.0 per cent, and Q4 at 5.8 per cent,” said Das.

The RBI, going forward, will remain watchful of inflation numbers in the context of economic growth.

“The FY24 GDP estimates, which are in alignment with the Budget numbers, probably remain on the higher side. That could be reassessed as we move forward,” said Rajeev Radhakrishnan, CIO – Fixed Income, SBI Mutual Fund. He expects this to be the last repo rate hike this cycle, with incremental actions to modulate excess liquidity.

Pause in rate cycle

The RBI has not made any change in its stance of - 'withdrawal of accommodation'. Experts are waiting for a change in stance to 'neutral', wherein the central bank decides to act on policy rates only if there is a compelling need to act.

Upasna Bhardwaj, Chief Economist, Kotak Mahindra Bank, expects a prolonged pause on rates with a likely shift in stance in the coming April policy. “Reinforcement of the need for action, as inflation remains above the medium-term target of 4 percent, signals the MPC’s focus on inflation. Going ahead, as inflation begins to moderate, we expect real rates to reach near the pre-pandemic level soon and hence the need for incremental rate hikes remains limited,” she said.

Nirav Karkera, Head of Research, Fisdom, found the outlook on inflation, consumption and growth optimistic, though the elevated core inflation numbers are a challenge. “Contrary to the widely held anticipation, the central bank retained its ‘withdrawal of accommodation’ stance with the hawkish undertone intact,” he said.

Put simply, though interest rates appear to have peaked, they may take time to go down.

The 10-year benchmark bond yield rose 3-4 basis points after the MPC announcement, indicating that the market has factored in the rate hike. Jajoo expects it to largely remain range-bound in the current band of 7.20-7.40 percent for the time being. “Short term rates are likely to move higher in line with the adjustment in policy rates,” he added.

What should you do?

Many investors are invested in very-short-term bond funds, looking at past returns. Though the past returns of medium-duration and long-duration funds have improved of late, they have not found many takers. Liquid funds and ultra-short-duration funds may continue to do well. However, it may be time to start looking beyond them with a view to lock in available yields.

“For the time being, investors should remain invested in short-duration debt funds with maturities up to three years as the yields are very attractive,” said Vikram Dalal, Founder and Managing Director of Mumbai-based Synergee Capital Services.

According to ACE MF, the average yield to maturity of short duration funds as on December 31, 2022 stood at 7.59 percent.

Ideally, investors should match their investment timeframe with the duration of a scheme. For example, if they have a timeframe of around three years, they may be better off investing in a short-duration debt fund with around two to three years duration.

“Considering the elevated probabilities of policy rates hitting a plateau sooner, fixed-income investors may seek to optimise on the relatively lucrative yields offered in the medium tenure of three to four years,” said Karkera.

Investors keen on visibility of returns can look at target maturity funds. To ride out the interest rate risk, be prepared to hold on to these investments till maturity. Since most of these invest in high-quality bonds, the credit risk is minimal, addressing the needs of conservative investors.

Long-duration funds, however, are an area where the experts differ. Dalal advises investors to wait for a while before deploying money in long-duration bond funds. Since the yields are almost similar on bonds across maturities beyond 4-5 years, investors are not getting compensated for staying invested longer.

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Karkera, however, is open to the idea of increasing allocation towards the longer end of the curve. “Investment in long-duration funds can help investors benefit from higher accruals and capital appreciation through the rate reversal cycle that is expected to follow the plateau in the medium term,” he said.

A point to note here is that long-duration bonds are more responsive to changes in yields. If the yields come down, the bond prices go up and vice versa. Investors need to assess their financial goals and risk-taking ability before signing up for investments in debt funds.

Nikhil Walavalkar
first published: Feb 8, 2023 02:44 pm