Opinion | Why debt mutual funds are giving negative returns and what you should do about it

Uncanny things are happening all over the world. For certain things, investors have a perspective, for instance, the equity market. People know that when there is a pandemic, the equity market will go through a correction. However, liquid and debt funds giving negative returns due to the current situation is unsettling for many people. It has left many wondering why and what they should do now. Let’s make sense of this.

To start with, there is nothing wrong with the debt market. As per investment theory, when the economy is not doing well, the equity market is also expected to not do well. However, it is a positive for the debt markets. The reason for this is, when the economy is not prospering, the demand for funds come down. When that happens, the interest rate, which is nothing but the cost of money, comes down as well. For a bond, the interest rate and price move inversely. When it is expected that the interest rate on instruments will be lower in the future, the price of today’s interest rate moves up. Which means, it’s good for prices of existing bonds. This is the situation we have today. Economic growth is expected to slow down and prices of today’s bonds should be higher. Why then, are prices coming down and debt funds giving poor returns? This is due to the stalemate in the money market (for instruments with a maturity of less than one year) and shorter maturity corporate bonds (maturity of one to five years).

The stalemate happened due to multiple reasons. People are working from home, but it is one thing to work from home and another to have a trading terminal. Even though we have the internet and technology, there are specialized trading terminals to avoid frauds available at offices but usually not installed at home. Foreign portfolio investors have also been selling heavily in both equity and debt markets, compounding the problem. It is not justified because for equity, India offers a better growth rate than developed countries and for debt, India offers higher interest rates. Banks are busy with their year-end issues and some public sector banks are going through consolidation. In times of uncertainty, banks are keeping the cash with them instead of taking investment decisions.

Mutual funds are facing redemptions. In the shallow secondary market for bonds and money market instruments, with traded volumes dwindling, the selling pressure is driving up traded yield levels, that is, pushing down the prices. This led to debt funds giving negative returns, because the instruments in the portfolio are marked to market every day for the valuation of net asset values (NAV).

So where is the hope? It’s there in the form of the Reserve Bank of India’s (RBI) helping hand. RBI has been doing things like purchasing government securities from the market to stimulate demand for them; infusing money into banks by introducing long-term repo operations (LTRO); and supplying US dollars to the forex market to make the rupee downfall less stark.

What RBI did on 27 March was a bang. It reduced the repo rate, which is the signal for interest rates for the economy, from 5.15% to 4.4%. It also reduced the reverse repo rate from 4.9% to 4%. Lower interest rates are expected to stimulate demand in the economy by making money available at cheaper rates. But the bang is not about rate cuts only. RBI started something called targeted LTRO, where money will be given to banks at the repo rate with the condition that it has to be invested in bonds and commercial papers (a money market instrument). This will lead to higher demand for these instruments. Yield levels will come down, prices would move up, and mutual fund NAVs will be better. So you will be better off with your investments in debt mutual funds.

What about fresh deployment in debt funds? There is a reason for interest rates to come down and, hence, it is a good time to invest. There are concerns about credit defaults because, typically, when the economy is in a downward cycle, business failures and defaults tend to be higher. Invest in banking and PSU funds and corporate bond funds, as their portfolio credit quality is relatively better. For very short-term deployment , there are evergreen categories like overnight funds, liquid funds and ultra short-duration funds, in which market-driven volatility is lower.

Joydeep Sen is founder, wiseinvestor.in