A reduction in policy rates will come with a reduction in market yields.
A reduction in policy rates will come with a reduction in market yields.

RBI rate cut: What should debt fund investors’ next step be?

  • A reduction in interest rates will affect different types of debt funds differently depending upon their portfolio
  • There are funds such as that seek to earn returns both from an appreciation in the value of the instruments along with coupon interest income

With the RBI coming through with a 25 bps cut in the repo rate for the third time in a row, the conviction of the experts that the domestic and global economic conditions warranted rate reduction action has been validated.

“The increase in output gap and the slowdown in the core sectors along with signals emanating from recent data has led the RBI to believe that a monetary push is required," said Avinish Jain, head-fixed income, Canara Robeco Mutual Fund. Moreover, RBI has also changed its stance from neutral to accommodative. What this means is that the low interest rate environment is likely to stay. “Whenever RBI has adopted an accommodative stance, there have been no rate hikes in the immediate future whether or not there have been additional rate cuts. They will also start going into surplus liquidity," said Jain. A low interest rate environment will affect different types of debt funds depending upon whether their portfolio is oriented towards accrual or duration.

Rate cut Impact on funds

Not all debt funds react similarly to a fall in market yields. Funds that earn their primary return from the coupon on the fixed income instruments will see a reduction in the interest income and, therefore, lower returns. These include overnight funds and liquid funds. These funds hold securities with very low tenors. In a situation where interest rates are declining, as instruments held in the portfolio mature, the money has to be reinvested in instruments that have lower interest income and this leads to a reduction in the return. There are funds that seek to earn returns both from an appreciation in the value of the instruments along with coupon interest income. When interest rates in the economy decline, the value of existing bonds that have higher coupons go up and funds that hold these bonds see their returns go up from the appreciation in value of the securities. Longer the tenor of the bonds, greater will be the impact of a change in interest rates on its value. Such funds include gilt funds, long- and medium-duration funds. However, these funds will see a greater cut in their NAVs when interest rates go up.

Does this mean that investors should shift to funds that are likely to benefit more? The answer will depend upon what the investor is looking for.

Stability for long term

If the fixed income portfolio is part of the core portfolio of the investor, the investor is looking to this segment of the portfolio to bring some stability to the portfolio returns. Funds that are most suitable for this are short duration funds, corporate bond funds, bank and PSU bond funds and such, running high credit quality portfolios with durations of 1-3 years. These portfolios will benefit to some extent from any reduction in market interest rates and with lower volatility in the returns. “With short duration funds running a duration of around one to two years and corporate bond funds two to three years, a 1% downward movement in yield can add around 1% to the portfolio’s returns in a year’s time," said Avnish Jain. “The spreads in corporate bonds is attractive. The 10-year spreads today is about 80-90 bps and similar could be in the three to five years bucket. In the corporate AAA side, there will be some juice left for investors to consider. With the recent credit episodes with DHFL, there will be greater demand for AAA, AA bonds which will compress the spreads further," he added. Bekxy Kuriakose, head-fixed income, Principal Mutual Fund, recommends high quality short duration and low duration funds for the strategic portfolio of the investor.

Tactical gains

If the intent is to take advantage of the expected fall in yields and the resultant appreciation in the price of bonds, then the investor should look for funds that have long duration bonds in the portfolio such as gilt funds, long duration portfolios and such. The returns from these funds will be volatile as the bond prices held will react more to changes in interest rates. “We use gilt funds and long duration funds for tactical plays when opportunities arise like the time in 2013 when the 10 -year G-sec yields touched 9% and there was an opportunity to make good capital gain in a short period," said Saurabh Bansal, founder, Finatwork Wealth Services, a Sebi-registered investment advisory firm. Kuriakose sees opportunities in well-managed credit risk funds and dynamic funds at this juncture to make tactical gains. For investors willing to stay with the volatility and give portfolio returns a boost, dynamic funds are a good option. These funds align the portfolio to benefit from duration when rates are expected to decline or from an accrual strategy when rates are likely to go up, and the focus is on earning and protecting coupon income. It frees the investor from having to time the market. The risk to investors is that fund managers may miss the cues on yields and the fund may under-perform the peers.

While a policy rate reduction was a foregone conclusion, the additional cues from the change in stance and focus on liquidity imply the possibility of low rates for some time going forward. Investors should focus on stability for the long-term and take tactical calls only in the satellite portion of their portfolio so that their goals are not affected by the volatility in such funds.

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