Four things debt investors need to do as RBI rate cuts taper off

The Reserve Bank of India’s (RBI) Monetary Policy Committee of the maintained status quo on policy rates by retaining the repo and reverse repo rates at the current levels of 4% and 3.35%, respectively, along with an accommodative stance. RBI made clear its intent of supporting growth at this stage rather than focusing on controlling inflation which at 7.6% is much above RBI’s comfort levels. Investors looking for cues to manage their fixed-income allocations must decode how RBI’s action affects their investment choices.

“The challenge is that RBI has to be sure that the revival in economic growth is sustainable and that would explain the accommodative stance. At the same time, there is the issue of inflation that seems persistently sticky at levels much higher than expected. The other complicating factor is that FII (foreign institution investor) flows on the equity side have been very strong and there has been some FDI flows too. This has constrained RBI actions on bond market interventions,” said Rajeev Radhakrishnan, head, fixed income, SBI Funds Management Pvt. Ltd. RBI also refrained from indicating any intent to moderate the excessive liquidity in the system that has pushed the yields on short-term securities such as treasury bills and commercial papers below the reverse repo rates. Even signaling their intent to do so may have helped them to condition market expectations and probably make eventual interventions less disruptive for the bond markets, added Radhakrishnan. Postponing the moderation of surplus liquidity may imply a more serious impact on the market when RBI does decide to unwind it.

The confluence of demand recovery, liquidity glut, high inflation and supply side constraints point to a tapering off of the rate cut cycle. Given the growth imperatives, an imminent rate hike is unlikely. Action on the liquidity front is likely to be the first step and this will put some upward pressure on yields from current levels. How do investors prepare their fixed-income portfolio for the changing scenario?

expect lower return

Investors in bonds and debt funds will need to reset their return expectations lower. The capital gains that added to the returns from debt funds is unlikely to continue since the cycle of falling interest rates and tightening spreads, which leads to appreciation in bond values, is for the most part over.

The rate cuts since early 2019 and the resultant gains in bond values translated into double-digit returns for debt fund investors. As the interest rate cycle turns, the mark-to-market impact of losses in bond values will pull down the returns. The impact of rate changes is more on portfolios holding longer duration securities. “We have communicated to investors that returns from debt funds will moderate in the range of 5-6%. It is important to give primacy to liquidity and safety,” said Kalpesh Ashar, Sebi-registered investment adviser, and founder, Full Circle Financial Planners and Advisors.

Stay flexible

Fixed-income portfolios need to be flexible to make the most of the uncertainty. Debt fund categories like dynamic funds that don’t have restrictions on the duration are well-suited to navigate the changing interest rate scenario. “When the rate cycles start to turn and the portfolio has to be adjusted to account for a bearish view on rates, the mandate restrictions will be a hindrance. A portfolio that has the flexibility on asset allocation and duration is best suited,” said Radhakrishnan.

In the non-mutual fund space, the 7.15% RBI Floating Rate Savings Bonds, 2020, also finds favour with investors looking for an accrual product that protects them from interest rate risk. The interest rates on the bond is reset every six months pegged to the National Savings Certificate rate plus 35 basis points. “For the portion of the debt portfolio where investors are not looking for liquidity, these bonds are suitable,” said Ashar.

pick strategies wisely

Understanding the interest rate and economic cycle while choosing strategies is important. A target maturity strategy that helps lock in the yields at the time of investing is best suited when yields are high and investors are able to tie into it. But, currently, when yields are almost at the bottom, this strategy may not be suitable.

Similarly, looking at credit risk funds and lower-rated products before there is greater strength to the revival in economic growth may be risky. “Given the uncertainty in corporate balance sheets, I would not recommend taking on credit risk now,” said Ashar.

Prevent return leak

Given the low returns scenario in fixed-income, look at ways to minimize the drain from taxes and costs. Invest according to the need for liquidity and asset allocation to make use of indexation benefits available on debt funds with holding periods above three years.

Arbitrage funds, which are taxed as equity funds, can also be considered for the short term. For investors who have a minimum three-month holding period, this category has the potential to provide better post-tax returns compared to debt fund categories suitable for this tenor. Select funds based on the expected holding period so that returns are not affected by exit loads that funds impose on withdrawals.

Short-term yields will see an uptick whenever RBI moves decisively on draining the surplus liquidity in the system. A hike in policy rates will depend on growth stabilizing meaningfully. Lower returns on short-term money should not worry investors as the priority should be liquidity and safety.

Investors using shorter duration funds for systematic transfer plans should stay with liquid funds, which have negligible mark-to-market component, to safeguard from any impact of a rise in yield. The return from debt funds is likely to be around the portfolio yield going forward since the avenues for capital gains to add to the return are slim.

Investors should consider debt funds aligned to their horizon for better post-tax returns and not get scared by interim declines in the net asset value. Don’t let the rate of return on a fixed-income product alone dictate the choice.