How to Approach Debt Mutual Funds As 10-Year Benchmark Yields Have Softened
Jul 29, 2019

Author: PersonalFN Content & Research Team

(Image source: Image by Deedster via Pixabay)

Since the start of the calendar year 2019, the Reserve Bank of India (RBI) has reduced policy repo rate by 75 basis points (bps)--25 bps each time --with CPI Inflation reading settling well within RBI's comfort zone.

To support growth, the RBI even changed its monetary policy stance from 'neutral' to 'accommodative' in its last monetary policy review meeting held in June. All six members of the committee took the decisions unanimously to support growth concerns.

Later in July 2019, Modi 2.0's full budget presented by Ms Nirmala Sitharaman, set the fiscal deficit target at 3.3% of the GDP for the current fiscal year (compared to a target of 3.4% set in the Interim Budget, presented in February).

In her maiden budget speech, Ms Sitharaman also stated, "The Government would start raising a part of its gross borrowing programme in external markets in external currencies (recognising India's sovereign debt external debt is among the lowest globally, at less than 5%). This will also have beneficial impact on demand situation for government securities in domestic market."

Subsequently, the proposal of issuing 'Foreign Currency Overseas Sovereign Bonds' drew criticism from certain economists and former RBI Governors. Here's what some said:

"Might they be short term faddish investors, buying when India is "hot", and dumping us when it is not? Could the resulting volatility in India's debt traded on foreign exchanges then transmit to our domestic G-Sec market? Would the foreign tail wag the domestic dog?" - Dr Rajhuram Rajan wrote in a column in the Times of India

Dr Rajan even questioned if India's fiscal situation and economic growth become so much healthier. He spelt out: "If the government wants to attract more foreign money to supplement domestic savings, it does not need to issue a sovereign bond; all it needs to do is to increase current ceilings on foreign portfolio investment into government rupee bonds. The effect is the same - more foreign inflows - but the government security is issued in rupees. So why issue a foreign currency-denominated bond?"

Even the former RBI Governor, Dr YV Reddy, highlighted that unless a limited liability company, government debt is held in perpetuity. There is no write-off of government debt when times are bad. Moreover, all governments are liable to pay off debts incurred by their predecessors notwithstanding whether they were democracies or despotic regimes.

Likewise, Dr C. Ragarajan too seemed sceptic, calling the move "risky".

Only Bimal Jalan, former RBI Governor, seemed backing the proposal to issue 'Foreign Currency Overseas Sovereign Bonds'. "At the moment we are in a fortunate position. Our debt to GDP ratio is not very high, exchange rate is stable, and foreign exchange reserves are high," Mr Jalan said in an interview to the media. "So foreign borrowing, if it's long term, which it would be, is not a problem", he added.

The Rashtriya Swayamsevak Sangh (RSS), the parent organisation of the Bhartiya Janata Party, also snubbed the proposal as "anti-patriotic". "We can't allow this to happen," declared Mr Ashwani Mahajan, the co-convenor of Swadeshi Jagran Manch (SJM), the economic wing of the RSS.

These voices were heard, and eventually, the Prime Minister's Office (PMO) stepped in asking the finance ministry to review/reassess the idea of issuing foreign currency overseas sovereign bonds, according to the news agencies Reuters and Cogencis. According to the news agency report, the PMO instead favoured rupee-denominated overseas sovereign bond issuances. And this is when owing to the confusion, the benchmark yield inched up a bit for a short while.

A point to note is India has never resorted to foreign currency borrowing even during the Balance of Payment (BoP) crisis of 1991. This is perhaps recognising foreign borrowers could get fickle when the foreign currency is volatile and demonstrate their discontentment in times where the going gets tough for the economy and when the path to fiscal consolidation is compromised.

However, now it comes to information that the finance minister has ruled out reconsidering a plan to issue 'foreign currency overseas sovereign bonds'. "I am not doing any review. I have not been asked by anybody to do a review," said Ms Sitharaman speaking to the Economic Times in an interview.

When asked about the details, i.e. the timing of the issue and the exact size, Ms Sitharaman said, "I don't think we have worked it out as yet." 

The Modi-led-NDA government plans to borrow nearly US$10 billion from the foreign overseas market, out of total planned borrowing of about US$103 billion in 2019-20.

The impact of above development on 10-year bond yields...

The announcement of 'foreign currency overseas sovereign bonds'--a bold move--has boded well (along with the other factors) for the 10-year G-Sec yields, driving them below 7.00%, to be precise at 6.50% as on July 26, 2019.

Graph 1: The 10-year benchmark yield on a roller-coaster, now near demonetisation levels...

The 10-year benchmark yield on roller-coaster, now near demonetisation levels
Data as on July 26, 2019
​(Source: RBI, PersonalFN Research)

The 10-year benchmark yield has softened by good 89 bps since the start of the calendar 2019 and since the 1st bi-monthly monetary policy for 2019-20 in April, by nearly 75 bps.

In November 2016, the 10-yr G-sec yields plummeted on account of ample liquidity in the banking system post-demonetisation of high-value currency notes.

Currently, in the last few months, although liquidity was constrained, the RBI has actively managed it via 'open market purchase operations'.

How debt mutual funds have fared?

Debt mutual funds with exposure to the longer end of the yield curve, i.e. medium-to-long duration funds, long-duration funds, Gilt Funds, and Dynamic Bond Funds have delivered double-digit returns in the last one year abetted by mellowed yields in a falling interest rate scenario. As you may know, yields and bond prices are inversely related; thus it left a positive impact on the NAVs of these debt funds.

So, should you invest in long-term debt funds?

While investing in longer duration debt funds makes sense in falling interest rate scenario, I would suggest avoiding these because most of the rally at the longer end of the yield curve has already come about.

If CPI inflation continues to move up beyond RBI's comfort zone, it would reduce the scope for further reduction in policy rates.

Graph 2: RBI's quarterly projection for CPI inflation (y-o-y)

RBI's quarterly projection for CPI inflation (y-o-y)
(Source: RBI's 2nd bi-monthly monetary policy statement for 2019-20)

The path of CPI inflation is revised upwards to 3.0-3.1% for H1:2019-20 and to 3.4-3.7% for H2:2019-20, with risks broadly balanced by the RBI in its June monetary policy statement.

The central bank has cited that risks around the baseline inflation trajectory emanate from:

- Uncertainties relating to the monsoon;

- Unseasonal spikes in vegetable prices;

- International fuel prices and their pass-through to domestic prices;

- Geopolitical tensions;

- Financial market volatility; and

- The fiscal scenario

Many of RBI's projections have come true.

The CPI inflation for June 2019 (data released in July 2019) rose to 3.18% from 3.05% in May 2019 due to increase in prices of food items (mainly pulses, meat & fish, milk, while inflation for vegetables declined), healthcare services and education.

Lower 'Core inflation' (which excludes food and fuel prices) reading of 4.09% for June 2019 and decline in cumulative CPI inflation, though, makes available some room for another 25 bps rate cut.

Plus, Ms Sitharaman is also hoping that RBI cuts rate.

"I'll honestly wish (for a) rate cut ... and yes, a significant rate cut would do a lot of good for the country. I am conscious that the RBI has taken a very accommodative posture and done nearly... 75 bps (basis points rate cut). We will now have to look at that route with a lot more hope. The industry also feels there is space for it" - Ms Sitharaman, speaking to the Economic Times in an interview 

So, what should the current investment strategy be when approaching debt mutual funds?

the current investment strategy
(Image source:

In my view, entering in longer duration debt funds perhaps at the last leg of the policy rate cut may prove imprudent and risky.

Although debt funds (especially those holding medium to longer-maturity debt papers) have seen a brief round of rally this year on account of successive rate cuts, they may still encounter higher volatility in the foreseeable future. Plus some of them already have exposure to downgraded and toxic debt papers which heightens the investment risk.

Ideally, you'll be better off if you deploy your hard-earned money in shorter duration and dynamic style debt funds, over longer duration funds.  But ensure you approach even short-term debt funds with your eyes wide open and pay attention to the portfolio characteristics and quality of the scheme. Prefer safety of principal over return. Stick to mutual funds where the fund manager doesn't chase returns by taking higher credit risks.

Further, asses your risk appetite and investment time horizon while investing in debt funds. While investing in short-term debt funds, consider keeping an investment horizon of at least 2-3 years. If you have an investment horizon of 6 to 12 months, ultra-short duration or low duration funds may be suitable. Avoid liquid funds that have very high exposure to Commercial Papers (issued by private entities).

Remember, investing in debt funds is not risk-free.

Alternatively, if you prefer to keep your capital safe, prefer fixed deposits.

[Read: Factors To Look At While Investing In Bank FDs]

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Happy Investing!

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