Find out how returns of income funds & g-sec funds will be impacted by the cut in repo rate
The general opinion among fund managers and market researchers is that the trend of declining interest rates is coming to an end, atleast for the short to medium term. This view has been put forward for several months now. Indeed, at Personalfn, we too have been of the opinion that investors in debt funds should not expect more than 7% pa in returns.
The performance of the debt mutual funds, however, has continued to be very steady, with some debt funds generating about 4.5-5.0% pa in the last six months (absolute, not annualised). Post the most recent cut in rates, returns would be even higher.
Does this mean that the much expected stabilisation of interest rates is not happening anytime soon and that debt funds will continue to generate double digit returns? Unfortunately, no. In fact investors should dilute hopes of further rate cuts. And, more importantly, they should not be surprised in case yields were to move up in the next few months.
Okay, the rise in yields part took you by a bit of surprise. In fact it probably seems very odd to read about the possibility of rising rates just when everyone else is celebrating the recent cut. But, it is necessary to present a contrararian view in this bullish environment.
In December 2002, Personalfn carried an article "Inflation: Will it dent your investments?" highlighting the possibility of a correction in the debt markets (debt markets subsequently did see a sharp correction in January 2003). This article again attempts to lay out a contrarian view that not only should investors tone down return expectations from debt funds, but they should also not be surprised to see a rise in yields in the short to medium term.
The following reasons lead us to put forward this view
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The Indian economy is showing distinct signs of a recovery. This is apparent from the faster growth in industrial production and a rise in imports. In fact, even the RBI has indicated that GDP growth could exceed the earlier projection of 6.0 -6.5% pa. A persistent rise in demand could heat up the economy (demand for money for both consumption and investment could rise faster than anticipated), prompting the RBI to take necessary action (no more rate cuts, or maybe even a rate hike in the medium term).
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The above average monsoon (so far) is all set to give a boost to the agriculture sector. A rapid growth in agricultural production will give a boost to the economy, which would add to the overall growth momentum. This would add to concerns mentioned earlier.
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The RBI Governor, a few days back, has stated that the flat yield curve is an issue i.e. the interest rate differential between the long term paper and near term paper is not adequate. The recent rate cut does attempt to solve this by pushing down near term yields. However, whether a single move will correct the yield curve is uncertain. In future, the RBI may attempt to resolve this issue.
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Bond yields in the US, Europe and Japan have risen sharply. In fact in the US, the last 15 days of June witnessed a rise of 1.4% in 10-year bond yields, the sharpest rise in 20 years! This rise in yields makes the global markets relatively more attractive when compared to India. A persistence of this scenario, could impact future fund flows to India, having implications for both the currency and interest rates.
So what should you do now?
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You should tone down expectations from debt funds to no more than 7% p. a. going forward.
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Avoid investing in sectoral debt funds (g-sec funds for example). Invest in diversified income funds so that the fund manager has some flexibility to deal with a not so favourable environment.
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Consider investing some amount in floating rate bonds, which offer much better protection in case rates were to head up or even turn volatile.
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Within your debt fund allocation, allocate some money to income funds, which invest in securities that are rated lower (AA+/AA) than the best quality (and therefore higher returns).
Finally, ensure that your investments are geared to meeting your objectives and are in accordance with the asset allocation plan that you may have drawn up for yourself. Do not get carried away in the euphoria that may surround the markets, be it debt or equity.
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