RBI’s worry on inflation can impact debt funds. Here is what investors should do

The RBI’s commitment to control inflation indicates that it is in no hurry to cut interest rates.

The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI), led by Governor Shaktikanta Das, chose to leave the policy interest rates unchanged.

Though the status quo was in line with market expectations, the MPC opted to raise the inflation target for the financial year, which may add to investors’ worries. In this context, experts advise investing in debt funds investing in bonds, maturing in the short term.

Inflation remains a key concern

Though inflation came down to 4.3 percent in May 2023, the inflation numbers are expected to be higher in July and August. Food prices remain a key variable and can push up inflation. The possibility of El Nino impacting the distribution of rains, and, thereby, farm output, can further push up prices. Globally, food and crude oil prices have inched up. Price of brent crude oil went to $87 per barrel on August 10, 2023, from $72 per barrel on May 31, 2023. These indicate a possibility of upward movement in inflation numbers.

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Accordingly, the RBI has revised the inflation expectation for FY 2023-2024 to 5.4 percent, which was set at 5.1 percent in the June MPC review. “We have to stand in readiness to go beyond, keeping Arjuna’s eye on the inflation front, deploying policy instruments, if necessary. I reiterate what I said in my June policy statement: bringing headline inflation within the tolerance band is not enough; we need to remain firmly focused on aligning inflation to the target of 4 percent,” the Governor said in his address announcing the MPC review outcome.

As a temporary measure to deal with excess liquidity in the banking system, the RBI has also directed scheduled banks to maintain an incremental cash reserve ratio (I-CRR) of 10 percent on the increase in their net demand and time liabilities (NDTL) between May 19, 2023 and July 28, 2023. This will be done, effective from the fortnight beginning August 12, 2023. This will be reviewed on September 8, 2023 or earlier. The governor further maintained that the existing cash reserve ratio (CRR) remains unchanged at 4.5 percent and there will be adequate liquidity in the system to meet the credit needs of the economy.

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How does that impact debt fund investors?

The RBI’s commitment to control inflation indicates that it is in no hurry to cut interest rates. The bond yields are expected to remain at the current higher levels for a longer period. Deepak Agrawal, CIO, Fixed Income, Kotak Mahindra Asset Management Company, says: “The RBI prefers to be in a ‘wait-and-watch’ mode to check if the recent food price inflation is getting generalised and prefers to keep rates on hold and to keep the monetary policy unchanged. The rate is likely to stay on hold for the rest of CY2023.”

If the RBI reverses the I-CRR by September, with a view to infusing liquidity in the September review or earlier, then that should soften short-term bond yields, other things remaining the same.

Short-term bond yields in a sweet spot

The benchmark 10-year bond yield remained flat at 7.17 after the MPC announcement. This may go up by a bit, if inflation actually goes up, as Das said the RBI expects.

Here is why short-term bond funds are comparatively less impacted than long-term bond funds. Investments in long-duration bonds expose investors to interest rate risk. When compared to this, short-term bonds appear attractive as one and two-year bond yields quote around 7 percent.

Dharmakirti Joshi, Chief Economist, CRISIL, says, “Mint Road seems staunchly focused on keeping consumer inflation within the 4 percent target, while standing pat on rates and monetary policy stance. The introduction of an incremental cash reserve ratio could temporarily harden short-term rates.”

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At present, it may not be the best time to look at debt schemes focusing on long duration. Instead, this could be an opportunity to look at debt schemes focusing on the shorter end of the yield curve.

What should you do?

According to the monthly data released by the Association of Mutual Funds in India (AMFI), liquid and money market funds saw net inflows of Rs 51,938 crore and Rs 8,608 crore, respectively.

After witnessing a net outflow of Rs 14,135 crore in June (the end of the quarter), debt-oriented schemes received a robust net inflow of Rs 61,400 crore in July. This clearly highlights that investors are more comfortable investing at the short end of the yield curve. This can be a good time to invest in short-duration debt funds, if you intend to hold your investments for 2-3 years. For those looking to invest for less than a year, investments in liquid, low-duration and money-market funds can be considered. Such schemes can help investors to take advantage of the current high yields. Short-duration funds and money-market funds have given 6.46 percent and 6.62 percent, respectively, in the one year that ended on August 9, 2023, according to Value Research.

Ideally, one should match their investment timeframe with the duration of the scheme. Also, check the credit quality of the portfolio.

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Sandeep Bagla CEO, Trust Mutual Fund, calls the monetary policy a cautious wait-and-watch one, with macros having turned negative since the last announcement in June. “In July, CPI headline reading will go close to 6.50 percent. The next few months would be a good opportunity to add duration to the portfolio, with a 12-month investment horizon,” he said.

As the interest rates may be closer to peak, this can be a good time to lock in interest rates. However, do not chase high yields, ignoring credit risk.