Budget’s high spending may affect your debt fund returns

Fixed income markets reacted negatively to the debt-fuelled growth-oriented budget that saw the benchmark 10-year yields breach the 6% mark.

“The higher level on the benchmark yield is an immediate reaction of the fixed income market to the large fiscal deficit and the impact it can have on inflation,” said Mahendra Jajoo, head-fixed income, Mirae Asset Management Company.

“However, inflation has been softening in the last couple of months and we expect the Reserve Bank of India (RBI) to give guidance on the supply management, so markets should stabilize,” said Jajoo.

A rise in yields will be a matter of concern for investors in total return products like debt funds where the return is a combination of interest income and gains or losses in the value of bonds.

Rising yields

Bonds lose value when yields go up. Investors used to double-digit returns from debt funds may now have to reset their expectations lower as rising yields will cut out the mark to market gains that they enjoyed so far in the rate-cut cycle.

“The returns that investors have been seeing in debt funds in the last one to two years were not sustainable over the next one or two years. For one, accrual levels are lower and second, mark to market impact won’t be favourable as yields inch up,” said Joydeep Sen, corporate trainer and author.

Jajoo added, “This is part of the cycle and investors should remain invested. This is also the time that fresh investments will happen at higher yields.”

Given that yields will move up, there will be an adverse impact on the returns from debt funds, and this impact will be higher for funds with a higher duration.

The short-duration debt fund categories with maturities between one and three years such as the low duration funds, money market funds, corporate bond funds, banking and PSU (public sector undertaking) funds and short-duration funds are best suited at this stage for investors to balance returns from accrual and the mark to market impact of rising yields.

Funds offering a roll-down strategy is something that investors who are uncomfortable with excessive volatility can consider to mitigate the market in their debt fund portfolio, according to Sen.

The other favourite of retail investors looking for guaranteed returns, the small savings schemes, may not see an immediate increase in interest rates even if the G-sec yields, to which their returns are benchmarked, goes up. This is because these schemes did not see a reduction in interest rates in 2020 even when G-sec yields saw a significant reduction.

A safety net

A positive for fixed income markets came from the proposal in the budget to set up a corporation that will purchase investment-grade bonds in periods of stress when liquidity in the corporate bond markets dries up quickly.

This comes as a welcome safety net for investors who have in the past experienced the consequences of poor liquidity in the bond markets.

“This is a good idea and will provide a sense comfort. It remains to be seen how it will be funded and wait for other details,” said Sen.

For their strategic allocation, debt investors should continue to stick to the basic investment principles of aligning their debt investment tenor to their investment horizon so that they are not caught short when money is required.

Strategic as opposed to tactical investing focuses more on long-term factors like financial goals than current market conditions.

Resetting their return expectation lower, staying with good quality paper and anticipating volatility will help them ride out this phase in the interest rate cycle.