What should be your debt fund strategy after RBI holds policy rates?

Belying the notions, the Reserve Bank of India (RBI) kept the key policy rates unchanged on Thursday priortising growth over inflation. The decision came amid news of rising interest rates from across the world. Consider this: inflation in the US increased to a 40 year high of 7.5 per cent signaling the series of rate hikes. Similarly, the Bank of England has announced back-to-back interest rate hikes for the first time since 2004.

Despite these global trends, the central bank of India has kept the rates unchanged exuding confidence that India can remain isolated from global monetary trends.

Monetary policy stance was kept accommodative in 5-1 voting. This probably means no rate hike in the near-term. "Monetary policy actions will be calibrated and well telegraphed,” said Shaktikanta Das, Governor, RBI, while announcing monetary policy on Thursday.

The RBI has projected retail inflation at 4.5 per cent for the financial year 2022-2023. RBI governor’s speech was, however, quite comforting to the bond market, as 10 year government bond yield declined to 6.75 per cent after his speech from its pre-policy level of 6.80 per cent.

“Against all odds, RBI left all key rates unchanged. Bond yields, which had gone up significantly over the last couple of months in expectation of the beginning of a rate hiking cycle, immediately came down sharply after the announcement of the dovish stance of the RBI Governor. While bond prices have gone up, there are multiple headwinds in form of rising global yields, the US Fed likely to hike rates multiple times in the near future, rising inflation and commodity prices, etc,” said Sandeep Bagla, CEO, Trust Mutual Fund.

In such a contrasting scenario what should be the strategy of debt fund investors?

Existing Investors: “As a result of the rally and continued promise of low interest rates in the future, existing debt investors reaped handsome returns on the policy day. Short term yields are likely to remain subdued and will be impacted by the effective overnight rates in the near future,” argued Bagla. The returns generated by debt funds have an inverse relationship with the interest rates.

In 2021 debt schemes ranging from liquid funds to long duration funds returned between 3-4 per cent, not even beating inflation while credit risk category funds that invest in relatively lower quality debt however gave higher return at more than 9 per cent.

New Investors: Debt investors should typically earn a return over expected inflation. There is a mammoth government security borrowing program starting from April which is likely to cap any rally in bond prices.

“One can expect range-bound movement in the 10-year Gsec rate from 6.50 per cent to 7 per cent over the next few months. New investors in debt mutual funds would do well to invest in schemes with a residual maturity of 2-3 years.

Funds with roll-down structures enable investors to earn higher interest income and benefit from the reducing maturity and interest rate risk of the fund as well. Investments should be divided between Banking & PSU Debt funds, short-term funds, and money market funds. One should expect returns close to 5 per cent over a one-year period if the funds are judiciously allocated over select schemes,” Bagla said.

Dhawal Dalal, CIO Fixed Income, Edelweiss MF, points out, “RBI governor’s dovish policy stance has given bond market participants a much needed respite after the initial shock from the Union Budget of FY23. While higher bond yields are inevitable in FY23, bond market participants are hopeful that RBI’s invisible hand will probably guide the bond market when the going gets tough and make the journey a bit more comforting. That said, we expect yield curves to remain steep in FY23. Steeper yield curves are likely to provide patient investors with sufficient risk-adjusted returns amid declining headline inflation.”

Dalal added that investors with long-term investment horizon should definitely consider investing in passively-managed bond ETFs or index funds maturing CY2026 onwards for superior tax-adjusted returns. They can do so by investing in 3-4 installments between now and September, 30, 2022.