Do debt funds look less attractive after the recent rate hike?
Sep 30, 2013

Author: PersonalFN Content & Research Team

Impact

Indian debt markets have been witnessing bouts of volatility for last few months. Falling rupee sent shivers down the spine of investors. RBI too was concerned with the pace and the magnitude of fall. In response, RBI hiked short term borrowing rates. This move surprised markets negatively and even liquid funds generated negative returns for next few days following this announcement. Debt markets were further affected by poor economic indicators such as stagnated industrial growth, sustained higher inflation at retail level and possibility of government overshooting fiscal deficit target among others. In August, yields on short term as well as long term debt instruments hardened due to liquidity crunch in the system and higher short term borrowing rates.

Recent developments…
But since the beginning of September, there has been a flow of some positive news as well. Indian exports recorded 13% rise in August which helped narrow down trade deficit. Decision of U.S. Federal Reserve to continue providing monetary stimulus, resulted in huge flow of capital to emerging markets. The newly appointed governor of RBI Dr. Rajan, took some reformative steps immediately after he joined. Markets were optimistic about RBI monetary policy turning pro-growth. Although not many market participants were expecting a rate cut, it was believed that short term borrowing rates might be rolled back. But contrary to these expectations, repo was hiked by 0.25% and Marginal Standing Facility (MSF) rate was lowered only by 0.75% (which was hiked 2.0% earlier) at the second quarter mid review of monetary policy.

A bumpy ride...
Yield on 10-Year G-sec Bond

Data as on September 27, 2013
(Source: CCIL, PersonalFN Research)

As depicted in the graph above, yields on 7.16%, 2023, benchmark 10 year G-sec bond are already up nearly 52bps since second quarter mid-review was conducted. But, reduction in MSF rates has helped yields on Certificate of Deposits (CDs) and Commercial Papers (CPs) to ease.

Under such circumstances, many of you might find it difficult to take a call on debt mutual funds. Before you device a strategy for such volatile market conditions, let’s first see how various categories of debt funds have performed so far.

How debt funds have fared?

	Returns (Absolute %)
Category	1 Month	3 Months	1 Year	YTD
Ultra Short Term Funds	0.98	2.11	8.41	6.21
Floating Rate Funds- ST	1.13	1.92	8.43	6.15
Income Funds- Short Term	1.55	0.85	7.64	5.28
Gilt Funds- ST	1.20	0.56	7.43	5.19
Floating Rate Funds- LT	1.17	1.42	7.39	5.19
Income Funds-LT	1.16	-1.39	6.14	3.63
Gilt Funds-LT	0.57	-3.84	5.13	2.39

YTD: Year to Date; i.e. from January 01, 2013 to September 27, 2013
(Source: ACEMF, PersonalFN Research)

Last year, it was widely believed that RBI may either maintain status quo or lower rates. Anybody may not have expected a rate hike. For this reason, investors had aggressively invested in long term income funds and long term gilt funds. But as shown in the table above, funds focusing on shorter end of the yield curve have done relatively well.

So what strategy investors should now follow?
RBI has already clarified that it will take hard steps as and when required irrespective of their unpopularity with markets and investors. Further, it also feels that consumer price inflation should act as a guiding force in deciding the direction of RBI monetary policy. PersonalFN believes that considering high consumer price inflation that still persist and rupee that still looks vulnerable; RBI may refrain from cutting rates in the near future. In fact, if needed it may hike rates again. This makes longer end of the yield curve unattractive. PersonalFN is of the view that investors should not hold more than 20% of their debt portfolio in long term debt funds.

Investors would be better-off staying with funds having shorter maturities. Liquid and liquid plus funds may benefit from liquidity crunch that still persist and wouldn't be affected much by lower MSF rates. Also, you should always consider your time horizon before investing in a debt fund.