Time to re-think debt fund strategy after RBI stance

Considered safe and huge protectors of wealth, most debt funds made large losses on February 7, the fateful day when the RBI governor surprisingly decided to hold interest rates. Some funds lost up upwards of 2% in a single day, shocking investors who were betting on interest rates staying lower for longer. Experts say that investors must re-think their play towards debt funds as the 'pause' in interest rates takes effect.

Debt funds are often marketed as more tax-efficient alternatives than boring bank fixed deposits. It is considered a given that investors cannot face any loss in debt funds. The market also adjusts ahead of major events like RBI monetary policy meeting. So, debt funds were positioned to benefit from a 25 basis point cut to the repo rate. By eventually changing monetary policy stance from accommodative to neutral, and not lowering rate, RBI told debt investors a very important thing: it does does not see scope for any immediate rate cut. This means many things for debt funds. As the RBI signaled the end of the rate-cut cycle, investors in bond funds may consider it a signal of the end of the superlative returns they have earned in the last three years.

Quantum Mutual Fund says,"The rate pause and the stance change have also sent a strong signal to the bond market on the market yield expectations. We do not expect bond yields to fall, and in fact the 25–30 bps sell-off seen after the policy announcement is indicative of the fact that the best times in the bond markets are behind us.

The bond markets have gone on a significant run since August 2013 with bond funds returning double digits. "But investors would do well now to lower their return expectations from bond funds. Capital gains may not be the driver of Indian bond returns. Also, if the RBI's warnings about global inflation come to fruition anytime in the near future, the bond market outlook will move to rate hikes instead of rate cuts further depressing returns from bond funds," added Quantum MF.

But totally writing off bond funds is not being advised. Killol Pandya, head fixed income, Peerless Funds Management, feels there may be some increase in corporate bond spreads in the coming weeks on the back of an expected increase in supply. "In our opinion, investors with a medium to long term investment horizon may consider investing in the bond markets in a calibrated manner," Pandya adds.

Bekxy Kuriakose, head – fixed income, Principal Pnb Asset Management?, is only a handful of those who had expect RBI to keep key rates unchanged. "However what was unexpected was the change in stance from accommodative to neutral....Going forward we do not expect any more rate cuts in CY 2017 as the stance has shifted to neutral. Long-term gilt and corporate bond yields to remain elevated as market repositions to new reality. Short-term corporate bond and money market yields to also rise however ample banking system liquidity to keep prices supported."

Dhaval Kapadia, director portfolio strategist, Morningstar Investment Adviser India feels its important for debt fund investors to understand the situation at hand. "On the fixed income side, given the change in policy stance, the attractiveness of long duration gilt and income funds seems to have reduced in the near term. Short-term income funds with good credit quality portfolios can be considered for additional investments," says Kapadia.

Not lowering interest rates is a view that the central bank has turned hawkish. Lakshmi Iyer, chief investment officer (debt) and head of products, Kotak Mutual Fund, feels it may be prudent therefore to continue to focus on accrual strategies predominantly, with a top of duration especially given the sharp spike in yields. Short-term funds, fixed maturity plans are classical examples of funds in which fund managers try and deploy accrual strategy, by typically looking for debt instruments that provide good yields and holding them till they mature (earning accruing interest in the process).

Debt fund investors betting on a quick reversal of rate-strategy may be shooting in the dark. Some economists feel RBI will stick to its stance for quite some time. Pranjul Bhandari, chief India economist, HSBC said, "We believe that the RBI will hold rates steady over the foreseeable future. The risk to our view is that growth, particularly investment, slumps sharply over the next few quarters and some space opens up. After all, the RBI has reiterated that with a neutral stance, it remains "fully flexible". But there too, the burden of proof will need to be high."