The Reserve Bank of India’s (RBI) on Friday cut repo and reverse repo rates by 0.4% each and announced its intention to continue its accommodative stance on interest rates. This usually leads to a jump in returns but this time yields on 10-year bonds did not fall by a significant amount, meaning that long-dated debt funds may not see major gains from the cut. On the flip side, short-dated funds such as overnight, liquid and ultra short-term will see a fall in returns due to yield reduction.
While debt fund managers are divided on the future trajectory of yields in the face of higher government borrowing, financial planners have suggested a cautious stance with emphasis on categories like short-term debt and PSU and banking debt.
Typically, the immediate effect of a rate cut is a jump in the net asset values (NAVs) of debt funds. This is because the prices of bonds rise when interest rates fall. The extent of the jump is given by a measure called modified duration. For example, a fund with a modified duration of 2 will see a roughly 2% jump for every 1% cut in interest rates. Gilt (government securities) funds which tend to invest in long-dated bonds, typically, see the biggest gains from rate cuts. However, this may not happen this time around due to bond yields failing to react in a big way.
But the rate cut is likely to lower returns on categories such as overnight, liquid and ultra short-term funds whose returns are connected to yields in the short-term debt market. These yields tend to drop when interest rates are cut and the impact of the gains or losses from changes in the values of the bond on the returns from these funds is limited.
Going forward, debt fund managers are divided on whether this trend will continue. “It remains to be seen what measures RBI takes to ensure smooth absorption of government borrowing," said Rajeev Radhakrishnan, head, fixed income, SBI Mutual Fund. Government borrowing tends to exert upward pressure on yields in the debt market. Earlier this month, the government announced an economic package of ₹20 trillion to revive growth. However, Mahendra Jajoo, chief investment officer (CIO), fixed income, Mirae Asset Mutual Fund expressed confidence about rates coming down further. He also dismissed concerns about the jump in food inflation to 8.6% in April that the RBI governor alluded to in his statement.
Financial planners, meanwhile, have recommended a cautious approach. “Even before the rate cut, short-term funds and banking and PSU funds looked attractive for investors. That continues to be the case for someone with a time horizon up to three years. If you’re only in liquid funds, allocate some part of the money to these categories," said Mrin Agarwal, founder, Finsafe India Pvt. Ltd, and co-founder Womantra. “Yields have fallen considerably at the long end for government bond funds, so don’t rush into these," she warned. Agarwal also recommended that investors should avoid funds that have high yields on account of credit risk.
Given the uncertainty in the overall economy due to covid-19, a low-risk approach tailored to your goals can work better than aggressive bets on either credit or duration (long-dated bonds). The latter have rallied considerably over the past year with their one-year return at 14.82%. However, they are extremely sensitive to changes in interest rates.