With the Reserve Bank of India (RBI) freezing the interest rates for now in its mid-quarterly monetary policy announcement on 16 December, the yields on 10-year bonds have come down in anticipation of softening interest rates in the next quarter or so. On 19 December, yields on 10-year bonds came down to around 8.35% from 8.48% on 15 December, a day before the policy announcement. The drop is sharper from the beginning of the month, 1 December, when yields were around 8.70%.

Shyamal Banerjee/Mint

Typically, fall in bond yields and the rise in bond prices augur well for debt mutual funds (MFs). So is it the right time to invest in debt funds?

The link between rates, bond prices and debt MFs

Bond prices are inversely related to interest rates. When interest rates rise, the yields of new bonds rise, but prices of existing bonds fall.

In order to remain competitive with new issues, existing bonds alter their prices. For instance, suppose a bond priced 100 pays 8%. If the interest rate in the economy rises and similar new issues start offering, say, 9%, the prices of existing bonds would go down for competition’s sake. In other words, the face value of 100 may reduce to around 94 for new customers to give the similar returns. Generally, for every 1 basis point change in yields, 10-year bond prices increase or decrease by 20 paise.

One basis point is one-hundredth of a percentage point.

On the contrary, when interest rates decline, the price of existing bonds increases and bonds are often sold at a premium to the face value to new customers.

Bond prices affect debt funds directly since debt funds largely invest in bonds. Here, when the bond prices go up (as interest rates outlook is weak and thereby bond yields are down), the net asset value of the fund would also increase.

Interest rate scenario

The Indian economy is under pressure owing to successive rate hikes during the last two years coupled with lack of reforms. In the last couple of months, the Index of Industrial Production (IIP) has been on a decline. In fact, in October, IIP contracted to -5.1%.

At the same time, though inflation is still above RBI’s estimates, it seems to be cooling off. The Wholesale Price Index-based inflation for November was 9.1% compared with 9.7% a month ago, the first moderation in headline inflation in over a year. Even food inflation has recorded a sharp decline; it fell to almost a four-year low of 4.35% for the week ended 3 December.

In view of the above factors, bankers feel that interest rates would now go down. “Considering the two factors, we believe that the first turn in the monetary cycle could come in the form of a CRR cut and may happen as soon as in the next quarter amid expectations of large additional borrowings," said Abheek Barua, chief economist, HDFC Bank Ltd, in the bank’s post-policy assessment report released on 16 December.

Agrees Melywn Rego, executive director, IDBI Bank Ltd: “I foresee the banking sector to cut interest rates only when RBI starts lowering the prevailing repo rates. It could probably happen during the first quarter of 2012."

Even the regulator has indicated that rates may head downwards soon. “The guidance given in the second quarter review was that, based on the projected inflation trajectory, further rate hikes might not be warranted. In view of the moderating growth momentum and higher downside risks to growth, this guidance is being reiterated. From this point on, monetary policy actions are likely to reverse the cycle, responding to the risks to growth," according to the press release issued by RBI on its mid-quarter policy review.

Should you invest now?

Experts say this is the right time... “In the future, in a falling interest rate regime, debt funds are likely to provide decent returns, particularly long-term debt funds," says Dhirendra Kumar, chief executive officer, Value Research, an MF-tracking firm.

While all kinds of debt schemes benefit in a softer interest regime, the benefit is virtually negligible in case of liquid funds and the highest in long-term debt funds, including gilt funds.

A look at MF returns in the last fortnight shows that medium gilt and long-term funds as a group have turned out to be the best performers among all MF categories. According to date from Value Research, the group has provided an absolute return of 1.86% in the last fortnight closely followed by income funds, whose category average return stands at 1.03% in the same period.

“There are views expressed in some quarters that it is better to wait for one more policy review as it would provide a much clearer picture. But in my view, customers should try to invest before the interest rate cycle starts heading downward as that would ensure customers benefit throughout the downward interest rate cycle and for that, this is right time as interest rates may start declining in January. Even if RBI maintains status quo the next time around, the softer interest rate regime would not be very far," says Rajan Krishnan, chief executive officer, Baroda Pioneer Asset Management Co. Ltd.

Rajan too favours long-term debt funds over short-term funds for those who are willing to take higher risk.

...but beware of the risks: In fact, you need to keep the risks in mind. In view of the depreciating rupee, inflationary pressure may come back to haunt again. In that scenario, the expected pace of interest rate moderation would slacken. And RBI has indicated such a possibility. “It must be emphasized that inflation risks remain high and inflation could quickly recur as a result of both supply and demand forces. Also, the rupee remains under stress. The timing and magnitude of further actions will depend on a continuing assessment of how these factors shape up in the months ahead," RBI has said.

India is a net importer and with domestic currency depreciating sharply against the US dollar, the cost of import is on rise and that may lead to inflationary pressure domestically.

The other factor that can affect you adversely if you invest now is the level of government borrowings. While the news of the chances of the government borrowing exceeding its original projection (owing to not meeting the disinvestment target) is priced in the yields, the slowing economy will reduce government revenues, thereby increasing the fiscal deficit. The latter scenario would once again firm up the prevailing yields owing to tighter liquidity in the market. If yields rise, your investments made now may suffer.