However, avoiding fixed income is not a smart move. This is where astute investors distinguish themselves from impatient and inexperienced ones. Let us understand why it makes sense to consider investing in debt funds in present market conditions:
Before investing in debt funds let’s look at the environment. Central banks across the world aggressively cut interest rates to stimulate the global economy. This was largely due to a massive slowdown caused by lock-downs announced to contain Covid-19 pandemic. As a result of this, ultra-loose monetary policy and aggressive fiscal measures were implemented by central banks and governments, respectively.
Too much money was printed. Though it brought economic activities back on track in many parts of the world, it also unleashed the deadly enemy of most investors and of course economic growth inflation. Inflation has been a chief concern for the past more than six months. High inflation impacts investments and decisions related to spending.
Now, keeping this context in mind, let us understand the investment situation in debt funds:
How much money debt funds made?
Since the beginning of the CY2021, fixed income investors had to deal with the dilemma of whether to remain invested in debt funds in a low interest rate situation or to exit or reduce exposure to debt funds as increasingly it was believed that interest rates would be increased to contain inflation.
Despite all the talk of inflation being transitory and commitment to support economic growth, interest rates were increased by central banks to deal with challenges emerging from the Russia-Ukraine war.
India too joined the global bandwagon of increasing interest rates when the Reserve Bank of India opted for an unscheduled hike of 40 basis points in repo rate—the rate at which the RBI lends money to commercial banks—and 50 basis points hike in CRR—Cash Reserve Ratio. As a result, yields spiked and bond prices fell pulling down the bond funds’ returns.
Corporate bond funds, short duration funds and Banking & PSU debt funds, some popular categories of debt funds, gave 2.02%, 3.48% and 2.39% returns in one year respectively on May 23, 2022.
Will there be a status quo?
Neither inflation nor geo-political tensions are going away too soon. In India, the retail inflation number for April 2022 was 7.79%. This was higher than expected. Bond yields jumped again and closed above 7.3%. Economists estimate that the RBI will raise interest rates in the June 2022 monetary policy meeting by 35 basis points. In FY2023, we expect RBI to hike repo rates to the tune of 115 bps.
RBI will not keep on increasing interest rates indefinitely. Though it wants to control inflation, it will not do so at the cost of economic growth. Too fast and too big upward movement in interest rates can impact economic growth. RBI also has to ensure that the large government borrowing programme succeeds.
In a volatile stock market, the government may not be in a position to achieve it's disinvestment target. In this context, the RBI may resort to some time-tested tools. These are: open market operations, operation twist in which it buys long-tenured bonds and sells short-term bonds and private placement of government bonds to RBI; to bring down the yields.
What should investors do about there investments in debt funds?
Rising yields is a phenomenon across the yield curve. The long term yields – the benchmark 10-year did not go up much. But the short term yields have spiked. In the last two years as well, the long-term rates did not come down much, whereas the short term rates did. The phase of upward movement in yields can last for a few more months. Though this may appear to be problematic and unfavorable for many investors in terms of returns, it also offers a good entry point to a few savvy investors.
Consider the case of 10-year bond yield. It closed at 7.36 on May 24 compared to 5.96 a year ago. It can move in the band of 7.20% to 7.96%. If the Russia-Ukraine war ends or at the least aggression from both sides comes down, issues related to supply chain will be addressed. This in turn may bring down inflation. As a result of this, yields may move up slowly.
This possibility cannot be ruled out. Higher yields can offer a good entry for investors with a minimum three year time-frame. In three to five years, yields may also come down. At such higher entry point real yields (nominal rate of interest minus the rate of inflation) may turn positive. And an investment at such a point will benefit investors.
Investors can consider target maturity funds for relatively predictable returns. Many mutual fund houses launched these schemes investing in good quality bonds with a clearly-defined maturity date. Some of these are relatively long term products – more than three years. Portfolio yields of such schemes have also gone up. If you have not invested in these, the current spike in yields can be utilized by investing in them.
If held till maturity, these schemes are expected to offer returns equal to current yield minus the scheme’s expense. Short duration funds and corporate bond funds can also be an interesting play for investors with a relatively lower investment horizon say three to four years.
Gains realized on debt fund units held for more than three years are considered as long-term and taxed at 20% post indexation. This makes such investments attractive for most investors. Savvy investors understand that the top and the bottom are identified only in hindsight. Hence, they prefer to stagger there investments when valuations turn attractive. Debt funds too may see continuous inflows over the next few months as savvy investors gradually build there exposure due to aforementioned reasons.
As of now, it is interesting to watch all the efforts taken by the government and the RBI to douse the fire called inflation. Investors will wait for the upcoming monetary policy by RBI for further clues and we will keep you updated on the same. Stay tuned.