These schemes invest in instruments that mature between one and three years and are ideally suited for your debt allocation
There’s some bit of good news for debt mutual fund (MF) investors. The Reserve Bank of India (RBI) has cut the policy repo rate by 25 basis points to 5.75 per cent from six per cent earlier. A basis point is one-hundredth of a per cent point. When interest rates fall, the prices of bonds rise and so do the net asset values (NAV) of debt funds that invest in them.
The benchmark 10-year government security fell to 6.91 per cent, down 11 basis points since Tuesday’s closing value of 7.02 per cent.
But that’s not the only reason why debt funds should cheer. After cutting interest rates for the third successive time this year, the RBI has also changed its monetary policy stance to “accommodative” from “neutral”. This stance means that a hike in interest rates is ruled out.
What’s the worry?
The RBI is worried about the low economic growth in India as well concerns abroad including the ever-increasing risks of trade wars. In its monetary policy note, RBI noted that there has been a decelerated growth in economic activity and private consumption has also gone down. The policy also noted that growth in manufacturing has also weakened. The RBI has revised its projection of the gross domestic product (GDP) growth for the fiscal year 2019-20 downwards to 7 per cent from 7.2 per cent in its April 2019 policy.
An “accommodative” stance on interest rates means that the RBI is open to further interest rate cuts, especially since it has noted that retail inflation is still far lower than the prevailing interest rates. Higher interest rates than inflation translate to a real rate of return.
“An accommodative stance, which is a change from the earlier neutral stance, means that there is no way that interest rates are going up in the next 6-12 months. This is good news for debt funds and debt fund investors,” says Marzban Irani, fixed income fund manager at LIC Mutual.
Should you rush to debt funds?
Sivakumar, head-fixed income, Axis Asset Management says that this “accommodating” stance “holds out the hope for one or two more cuts in interest rates in the near term. The risk of negative surprise in interest rates rising has substantially reduced.”
Also, the yield difference between AAA- and AA- rated bonds and the 10-year benchmark g-sec(government security) yield also gives a clue to whether it makes sense to invest in debt funds or not. If the gap between the two yields (for the same duration debt scrip) is wide, then the chances of the bond yields coming down are high. According to Bloomberg data, the yield on 10-year AAA-rated bonds are still 100 basis points higher than the 10-year g-sec yield. The gap between AA-rated yields and the 10-year g-sec yield are much wider – about 175 basis points.
That being the case, it makes sense to invest in debt funds, if you haven’t done that already. The question is: which debt fund?
Debt funds come in varying maturities. In simple words, different debt funds are meant for investments made for different tenures. Schemes from the liquid, ultra short-term and short-term debt categories cater to those who wish to invest for a shorter duration; long-term bond funds and government securities (g-sec) funds are meant for longer investment tenures of five years or more. Typically, a fall in interest rates−or better still, when interest rates appear to be on a decline−debt funds with longer tenures tend to benefit more. The latter move faster with interest rate changes, whether rates go up or down.
Moneycontrol suggests that you avoid long-term bond funds and g-sec funds. More so the latter, as they are volatile funds and more seasonal. “The small investor may not be able to withstand the volatility that comes with g-sec funds. And although interest rates are expected to go down in the near term, they need not remain a long-term trend at the moment. In that case, the gains from g-sec funds can easily be reversed,” says Shriram Ramanathan, Head – Fixed income at L&T Investment Management.
Should you then park your money in liquid funds? Not quite. First, liquid funds are not investment vehicles. These are funds meant to park your surplus cash because they invest in scrips that mature overnight or at the most in about 40 days. But effective June 20 this year, they will be required to mark to market all their securities that mature beyond 30 days. So, returns from liquid funds can come down as, until now, liquid funds marked-to-market only those securities that mature beyond 60 days. To keep their volatility in check, liquid funds typically invest a chunk of their portfolios in securities that do not mark-to-market their portfolios. By restricting their portfolios to 30 days’ maturity, liquid funds will be less volatile, but experts say their returns will be constrained too.
Consider short-term bond funds and banking and PSU debt schemes. These funds invest in scrips that mature between one and three years and are ideally suited for your debt allocation given RBI’s policy rate cut and the direction in the next 6-12 months. “Stick to high-quality portfolios funds like Banking and PSU funds if you are risk averse; they’re also ideally suited for a three-year time horizon. Short-term funds’ portfolios are more actively-managed and here they can invest in AAA- and others in AA- rated securities as well. But it’s best to stick to those debt schemes that stick to high quality securities,” says Sivakumar.
Adds Ramanathan: “The 1.25 per cent to 1.75 per cent returns kicker that short-term bond funds offer over liquid funds is very reasonable.”
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