For the past few months we have been hearing a lot about the happenings in the debt markets across the globe. While the global economy has been struggling to get over issues such as Euro zone sovereign crisis US debt ceiling and subsequent rating downgrade to name a few; back home, the RBI has been taking some aggressive policy rate actions. Now you would be wondering if there is so much of uncertainty even in debt market investments then how you will be able to park your safe funds which you need after some time and what should be your strategy if you wish to invest in domestic debt markets which are relatively safe compared to wildly swinging domestic equity markets. Will your debt investments be able to outperform your equity investments?

But before moving on to the argument of expected performance of debt vis-à-vis equities, first let us understand the factors that have impacted the domestic interest rate movement and debt instrument performance so far.

Inflation and interest rates are two data points that are closely watched not only by the central banks but also by economists and market pundits. There will rarely be two opinions about their usefulness. Low to moderate inflation and benign interest rate scenario is considered a precursor of high growth.

In India, RBI controls the flow of money in the economy. It pumps in or sucks out liquidity depending on the level of inflation and the estimated growth expectations. Inflation has been persistently high for more than a year now and it is clearly out of the comfort level of RBI. RBI has waged a war against the stubborn inflation by raising policy rates for 11 times successively since March 2010.

Chart below shows that despite all the hard work done by RBI to tame inflation, the WPI inflation has not been able to calm down convincingly. After dipping marginally in May 2011, the WPI inflation again resumed its upward movement.

 

(Source: Office of Economic Advisor, PersonalFN Research)

 

This is typically witnessed when the demand for goods and services in the economy exceeds the supply. Hence by using monetary intervention tools such as repo, reverse repo, RBI tries to cool off the overheating; but it is well aware that if done excessively, it may hurt the economic growth as with rising interest rates, cost of goods produced in the economy goes up there by affecting the profit margin of corporate Inc.
 

Policy rate tracker

	Increase / (Decrease) since March 2010	At present
Repo Rate	325 bps	8.00%
Reverse Repo Rate	375 bps	7.00%
Cash Reserve Ratio	100 bps	6.00%
Statutory Liquidity Ratio	(100 bps)	24.00%
Bank Rate	Unchanged	6.00%

(Source: RBI website, PersonalFN Research)

 

Table above indicates that RBI has hiked repo rate by 325 bps (1 basis point is 1/100th of a per cent.) since March 2010. Repo rate is the rate at which RBI lends to the banks. Any hike in the repo rate would make the borrowing from RBI dearer to banks thereby increasing their cost of fund and eventually will also impact the lending activities of the banks.

On the other hand, Reverse repo is the rate at which banks place their excess surplus with RBI, and thereby sucks excess liquidity out of the system. In other words, in case the banks do not find enough borrowers meeting their risk management criteria, then banks can park their excess money with RBI through reverse repos.

What has kept the WPI inflation beyond control?

Food inflation is still very high at around 8%. The rise in wages have increased the buying power and improved the quality of food intake and demand from the people in the rural region and thus the food prices. The shortage of food supply to meet this demand has kept the upward pressure on food prices. Apart from food inflation, the high crude and commodity prices across the globe has added a significant upside pressure on the WPI Inflation.

 

Our View:

RBI has been hiking policy rates relentlessly for more than a year now and there is a limit as to how much a rate hike can curb the inflation. In order to bring the food inflation under control, more than a policy action, normal or above average rainfall (especially in agriculture prone areas) may come to rescue hereon. However the monsoon this year is 6% below the average between June 1 and August 2. As the supply side pressure is beyond the direct control of RBI, it has been trying to control the demand side pressure by reducing the surplus in the hands of a common man. Or at the most its actions may indirectly increase the prices of goods and services thereby making it unattractive and beyond the reach of common man and hence the demand. But not to forget, high material cost, funding cost and slowdown in demand for end goods and services will also impact the overall economic growth.

Many experts in the industry have already raised their concerns on the aggressive rate hikes. Rajiv Kumar, secretary general of the Federation of Indian Chambers of Commerce and Industry (FICCI) opined that "With the growth momentum already under pressure, this move (the recent rate hike) will further hurt future prospects."

While, India and China are raising rates; western economies are still grappling with the problem of sluggish economic recovery, which now has become a major concern due to debt overhang and credit rating downgrade of US and the prevailing debt crisis in the Euro zone. Under such a scenario there would be a limited room left for the central bank to raise rates further. That makes us believe that we are nearing the peak of the current interest rate cycle.

What are debt investments offering now?

While we believe that interest rates are nearing their highs and become more attractive, many banks and NBFCs are offering attractive interest / coupon rates on their Fixed Deposits. Even many NBFCs and corporates are raising funds through Term / Fixed Deposits and also by floating Non-Convertible Debentures (NCDs) with attractive coupon rates.

Not only fixed deposits but also debt mutual funds which invest in these debt instruments and earn regular coupon as well as capital gain on their investment portfolio are able to offer attractive yields to the investors when the interest rates near their peaks. Debt mutual funds are in a way considered convenient for retail investors, who with a small investment amount want to diversify their portfolio across and benefit from various highly rated and high yielding debt instruments. We call it highly rated and high yielding debt instruments portfolio because the fund manager considers the credit quality as well as coupon offering and the prevailing yield on each instruments in which he invests, and thus make an optimum balance between credit quality and yield.

The right strategy to invest in debt mutual funds

Almost all debt oriented mutual funds (especially the duration funds) tend to do well when the interest rates start falling. However before you zero on the category of a debt mutual fund you wish to invest in, you must understand your liquidity requirement. Chart below would help you choose the right category of debt funds depending on your investment horizon.

 

Type of Fund	Time Horizon	Liquidity requirement
Liquid Funds	less than 3 months	Very High
Liquid Plus Funds	3 to 6 months	High
Floating Rate Funds	6 to 12 months	Medium
Short-term Income Funds	Strictly 1 year and above	Medium
Fixed Maturity Plans of 3 months to 15 months	Hold till maturity	Medium
Dynamic Bond / Flexi-Debt Funds	2 to 3 years	Low
Pure long-term Income Funds	3 to 5 years	Low
Government Securities Funds	3 to 10 years	Very Low

(Source: PersonalFN Research)

 

So, say if you have a very short-term time horizon (of less than 3 months) and liquidity need is paramount, you would be better off investing in a liquid fund. Similarly, if you need funds after a period of 3 to 6 months, then liquid plus funds or for 6 to 12 months period, floating rate funds would be ideal for you. The idea is to match the average maturity of the underlying portfolio with that of your holding period. When repo rate is at 8% and the reverse repo is 7% you may expect a well-managed liquid plus scheme to yield in the range of 7%-8% p.a. as fund managers can expect a slightly better rates from money market instruments issued by banks, NBFCs and corporates and even from other money market instruments like CBLO and T-Bills.

Short term income funds are favourable for one who has a time horizon of at least 1 year as cash starved banks and NBFCs are offering their short term instruments like 3 months to 1 year CDs at more attractive rates and gain when the RBI stops further rate hikes and stabilises interest rates.

Long term debt mutual funds are more sensitive to the interest rate movement than the short term income funds. Hence once the interest rates start falling they stand to gain more. But we advise you not to trade on by timing the interest rates. We re-iterate that you should first fix your time horizon and strictly follow it. One with a time horizon of 2 to 3 years can start with a Dynamic bond or Flexi-debt kind of fund as they usually have privilege to shift between short term and long term instruments at any point of time based on the fund managers views and conviction. Invest in a pure long term fund (investing only in long term instruments) if your time horizon is 3 to 5 years.

Gilt funds invest primarily in Government securities. They carry near zero default risk but not many know that they may tend to be volatile in the near term due to change in sentiment and activity of the participants with any news flow or action by RBI. One can gain in Gilt mutual funds in a falling interest rate scenario but may lose if there is any significant up move in interest rate on long term G-secs. To be better off investing in Gilt Funds, you need to keep a longer investment time horizon.

Aggressive investors may benefit from allocating funds towards MIPs (Monthly Income Plans) as they predominantly invest in debts and also do have a flavour of equities (upto 25%) which enhances the chance of creating alpha if equity market turns supportive. Investment in this category can benefit from any significant up-move witnessed in debt market as well as equity markets.

However it remains to be seen if your debt mutual funds outperform equity as an asset class this year.

 

This article was written exclusively for Equitymaster, India's leading Independent research initiative. Trusted by over a million members all over the world, Equitymaster is known for its well-researched, unbiased and honest opinions on the Indian Stock Market.

 

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