While overnight and liquid funds will see lower returns, short-duration funds may benefit from valuation gains
For debt market investments, align your expectations for lower returns as rate cuts get transmitted to the real economy
In a widely expected move, RBI cut the policy repo rate by 35 basis points (bps) to 5.4% in its monetary policy committee (MPC) meeting on Wednesday. This makes it the fourth rate cut in a row since the first MPC chaired by RBI governor Shaktikanta Das in February 2019. In all, RBI has reduced the repo rate from 6.5% to 5.4% in this period.
In a bid to enable efficient transmission of lower policy rates to the real economy, RBI has also been focusing on adequate liquidity in the system and this was reiterated by the governor. The non-banking finance company (NBFC) sector that is facing stress was given support in the form of liberalizing the exposure that banks can take to any one entity to 20% of the tier 1 capital and designating certain advances to NBFCs as priority sector lending. RBI’s actions will translate into consequences for the debt allocation in your investment portfolio. We tell you the changes you may see in your debt investments.
Overnight and liquid funds: Overnight and liquid funds are likely to see lower returns as rates come down. The returns for these funds come from the interest rate earned on instruments they hold. The impact of the rate cuts in the calendar year and the excess liquidity in the system has already been seen in lower yields in money market instruments and this translates into lower returns from these schemes.
Overnight funds, typically, invest in collateralized lending borrowing agreements (CBLO), reverse repos and money market instruments with residual maturity of not more than a day. The returns from overnight funds, thus, reflect the overnight rates for lending and borrowing in the market. “The overnight rates typically go below repo rates in situations of excess liquidity," said Arvind Chari, head of fixed income and alternatives at Quantum Advisors Pvt. Ltd.
Liquid funds invest in instruments with tenures up to 91 days. Most funds hold investments with less than 30 days to maturity. Given the low tenure of the instruments held by these funds, the contribution to total returns from gains in the price of bonds—as a result of softening rates—will be minimal. However, these funds are not to be included in the portfolio for their returns. They are meant to give you the benefits of liquidity, stability and capital protection.
Funds for short-term needs
Ultra-short and low duration funds: Ultra-short and low duration funds are likely to see some benefit from gains in the value of securities held. These funds are able to earn that extra bit of returns by managing the portfolio within the prescribed duration limits to earn some capital gains. Ultra-short fund portfolios can run a modified duration of up to six months and low duration funds of up to nine months. Funds holding longer duration instruments will benefit more from the reduction in yields.
These are funds that are used for time-bound needs such as holding the corpus to meet a goal in the near term, accumulating funds through the year to meet an anticipated annual expense, a systematic transfer plan and so on. Investors may consider the fund category to earn better returns than short-term fixed deposits with flexibility of tenure. The credit quality of the portfolio should be a prime concern for you.
Funds for core allocations
Short duration and corporate bond funds: Short duration and corporate funds that run durations of one to three years are likely to see a positive impact on returns as the fall in yields and the resultant appreciation in the value of bonds will add to the total returns from such funds. “Easier liquidity and reduction in policy rates in an environment of monetary easing should benefit funds concentrated at the short-medium end as the transmission is more direct in this segment. Funds such as corporate bond and short duration continue to remain attractive considering the moderate duration as well as higher credit quality exposures," said Rajeev Radhakrishnan, head of fixed income at SBI Mutual Fund. “The one-to-three-year space for both government and corporate bonds may see rates coming down and this can bring some mark-to-market gains to these funds," said Chari. But he cautioned about the lower returns in these funds going forward—as rate transmission happens, the portfolio yields will come down. Government securities (G-secs) being the most liquid segment, the rally happened there first. In any cycle, it takes some time for corporate bond market yields to come down but there is potential for that to happen going forward. The additional impetus for lending by the banking sector to the NBFC segment and resolution of the credit issues in this sector will aid this rally.
Investors would typically use short duration and corporate debt funds to make the debt allocation for your core portfolio needs, say, moving the accumulated corpus when the goal is one to three years away or saving for a goal that is one to three years away. Short duration funds have to limit the modified duration of the portfolio to three years and most funds in this category run durations between one-and-a-half and two-and-a-half years. This limits the extent of volatility. Corporate bond funds that run portfolios with duration of one-and-a-half to three years and hold at least 80% of the portfolio in AAA and equivalent rated instruments are also well-suited for core portfolio needs since here the volatility is contained.
Funds for tactical allocation
Medium to long duration and gilt funds: Funds that have portfolios with longer durations have already seen the benefits of yields coming down in the last one year. With the 10-year G-sec at 6.3%, there may not be another rally even if there are more rate cuts. The risk-reward ratio is better at the shorter end at this stage. Higher duration means there will be greater volatility in the returns that makes the funds suitable only for tactical exposure—to take advantage of falling yields. Tactical allocations to such long-term funds can be a portfolio return booster when conditions are favourable. Reading the indicators correctly to the time of entry and exit is important.
RBI seems to have left room for one more rate cut this year and the accommodative stance is likely to continue till the economy is on firm grounds. The decline in G-sec yields implies lower interest on small savings schemes like PPF, SCSS and others, whose yields are linked to G-secs.
If you are invested in the debt market, you should realign your expectations for lower returns as the rate cuts get transmitted to the real economy and fixed deposit rates and debenture yields also see a decline. In such a situation, debt funds that meet your needs for liquidity, core allocation or tactical benefits may be the best options to explore.