Mumbai: Apart from cutting the benchmark repo rate by 25 basis points for the second time in a row, the Reserve Bank of India (RBI) on Thursday also announced measures to increase liquidity to ensure that the effect of the rate cut actually makes it to the real economy.

Higher liquidity chasing the same volume of debt pulls down market interest rates. This, in turn, increases the value of bonds issued at older rates, particularly long-dated bonds. Savvy investors who bought into long-dated bonds and long-duration debt funds have already pocketed decent levels of gains, with the yields in the market already having factored in a rate cut.

So what does the rate cut mean for investors in fixed-income products, including debt funds? Debt investors either look for the stability of pure interest income or for higher total return, which is a combination of interest income and gains from the appreciation in the price of the securities, albeit with higher volatility. The choice of the debt investment usually reflects this.

Investors seeking the comfort of an assured fixed income should consider tying into the higher yields of government-administered small savings schemes and bank fixed deposits (FDs). Some of these schemes allow you to lock into a rate, while others have their rate reviewed every quarter. The caveat is that if government securities yields, to which the interest rates of these schemes are benchmarked, rise either on account of rising oil prices or the monsoons playing truant, then we may see higher rates in the coming quarters. Many of these schemes also offer tax benefits that makes post-tax returns from them attractive.

Apart from bank FDs, another option for investors seeking to lock in higher yields is buying non-convertible debentures (NCDs). A slew of these is set to be launched, including the second tranche of L&T Finance NCD and Sriram City Union Finance NCD. “Investors with large debt portfolios can think of investing in higher-rated NCD issues which are coming up, to get the benefit of rates north of 9%," said Mahesh Mirpuri of Invest Mutual, a Chennai-based mutual fund distributor. But the post-tax returns may not be as attractive and the credit risk in these bonds need to be closely watched.

The latest rate cut has raised two key questions for the category of investors looking to earn total returns. First, whether there is a case for investors to buy long-duration or gilt funds to capture the ongoing rate cutting cycle.

On this question, fund managers advise caution. “A moderate approach through short- or medium-term funds is advisable. Those who want to take duration calls can make tail (small incremental) allocations to gilt funds," said Lakshmi Iyer, head, fixed income, Kotak Asset Management Co. Ltd.

“Corporate bond funds are also a good alternative," she added. This is on account of their high-grade bonds which are relatively liquid and their lower expense ratios. Corporate bond funds are mandated by capital market regulator Securities and Exchange Board of India (Sebi) to invest 80% of their assets in bonds with the highest credit rating (such as AAA). However, there are no restrictions on the duration calls they can take. Typically, they have average portfolio maturities of one to three years.

Should investors with short investment horizons consider moving out from liquid funds? Given that the rates in very short-term instruments, in which liquid funds invest, are going to be the first to see the impact of the rate cut, returns from liquid funds could suffer.

This question is also pertinent for investors in systematic transfer plans (STPs) of liquid funds for transferring funds to equity funds. “We had already recommended a shift from the liquid to the low-duration category for investors doing STPs. A rate cut cycle only strengthens this argument," said Devang Shah, deputy head, fixed income, Axis Mutual Fund.

Deepali Sen, founder-partner of Srujan Financial Advisors, said that retail investors are more concerned about liquidity and safety in their short-term investments rather than returns. “For an emergency corpus, people can continue in liquid funds. However, STP investors can look at the ultra short-term or low duration category. This is because a typical STP lasts for at least 12 months," she added.

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