Reasons Why Bond Yields Have Softened And How To Approach Debt Funds Now
Jun 08, 2019

Author: PersonalFN Content & Research Team

(Image source:Image by stock snap from pixabay)

Economic growth is under the weather.

Importantly, RBI has now decided to recognise it as a problem.

In the second bi-lateral monetary policy review of FY20, RBI decided not only to shift its policy stance from neutral to accommodative, but also decided to reduce the policy rate to 5.75% i.e. by 25 basis points.

RBI's rate cut rationale couldn't be clearer than this...

The Monetary Policy Committee (MPC) notes that growth impulses have weakened significantly as reflected in a further widening of the output gap compared to the April 2019 policy. A sharp slowdown in investment activity along with a continuing moderation in private consumption growth is a matter of concern. The headline inflation trajectory remains below the target mandated to the MPC even after taking into account the expected transmission of the past two policy rate cuts. Hence, there is scope for the MPC to accommodate growth concerns by supporting efforts to boost aggregate demand, and in particular, reinvigorate private investment activity, while remaining consistent with its flexible inflation targeting mandate.

Unless, you are a market- savvy observer, you are probably going to miss the conviction with which RBI is moving towards lower rates.

Some facts:

  • RBI's 6-member Monetary Policy Committee (MPC) has unanimously voted for change in the stance (with no vote against the proposal)

  • Similarly, all members voted for lowering the interest rates, which now stand at a 9-year low. Did you know for the first time since July 2010, we are seeing a sub-6% policy rate?

  • RBI has lowered the GDP growth forecast from 7.2% to 7.0%.

  • Despite the chance of experiencing a higher food inflation, RBI expects overall retail inflation to remain in the range of 3%-3.1% in H1:FY20 and to 3.4%-3.7% for H2:FY20.

Since it was a well anticipated move, the rate cut and change in the policy stance hasn't cheered the capital markets. In fact, equity markets tanked soon after the announcement.

Was this a shocker?

Against an indicative Basel III Leverage Ratio of 4.5%, RBI prescribed the minimum Leverage Ratio of 4% for Domestic Systemically Important Banks (DSIBs) and 3.5% for other banks.

In other words, to ensure financial stability and adhere to Basel-III standards, RBI has tightened the screws around banks. Now banks will have to either lend less or introduce more capital.

Equity markets weren't happy with this development and carnage in banking stocks dragged down the leading indices. Following RBI's pro-growth policy stance, India's 10-year benchmark bond yields dropped to an 18-month low of 6.9%.

On this backdrop, should you expect good times to return to debt funds?

Experts believe, now that RBI has adopted an accommodative stance, it may look to lower rates as and when the current inflation and inflation expectations permit it to do so. As you would know, bond prices and bond yields move in opposite direction. Hence, usually under such a scenario investors go gaga over debt funds.

If you are planning to invest aggressively in debt funds, here's a word of caution

You shouldn't ignore the credit quality issues India faces today. Some stressed debtors are expected to unsettle India's financial system for some more time. DHFL's dramatic credit downgrade to D from AAA about 9 months ago highlights the urgent need for debt mutual fund investors to be cautious.

Although Modi 2.0 has assured markets that it will find the resolution for the IL&FS crisis within the next 100 days, you as an investor still need to be wary of the spillover effects the IL&FS' debt fiasco might have already caused.

With the recent rate cut, RBI has lowered the policy rates by 75bps over the last six months, and now it expects banks to pass on the benefits to the borrowers.

Transmission of the cumulative reduction of 50 bps in the policy repo rate in February and April 2019 was 21 bps to the weighted average lending rate (WALR) on fresh rupee loans. However, the WALR on outstanding rupee loans increased by 4 bps as the past loans continue to be priced at high rates. Interest rates on longer tenor money market instruments remained broadly aligned with the overnight WACR, reflecting near full transmission of the reduction in policy rate.

We are in an awkward situation; wherein borrowing cost for the deserving borrowers is likely to fall steeply. Nonetheless, making any assumption about the future credit quality of the instrument is extremely risky. A year ago, who would have thought IL&FS and DHFL would default?

Companies and NBFCs with fragile credit profile will have to offer higher coupons to attract investors. You should be wise enough to avoid them. Companies with poor fundamentals may try to raise money to sustain them for the long term before it gets too late.

What investors should do?

Investing aggressively at the longer end of the yield curve could prove imprudent, although the RBI has taken an accommodative stance. So, long-term debt funds (holding longer maturity debt papers) can encounter higher volatility in the foreseeable future. If inflation moves up, it will then limit RBI's scope of reducing policy rates further. Currently, shorter maturity papers are more attractive.

So, ideally, you'll be better off if you deploy your hard-earned money in shorter duration debt funds, instead of longer duration funds. But ensure you approach even short-term debt funds with your eyes wide open and paying attention to the portfolio characteristics of the scheme. Stick to mutual funds where the fund manager doesn't chase returns by taking higher credit risk. Furthermore, it is important to assess your risk appetite and investment time horizon before investing in debt funds.

This article first appeared on Certified Financial Guardian.


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