Debt Fund Opportunities
To understand how debt mutual funds react to increases in the repo rate, we analysed a few past occurrences when the repo rate was increased. We attempted to figure out the performance of debt funds three months previous to the increase in the repo rate, as well as three months, six months and one year following the increase in the repo rate
In the quarter ending March 2020, the stock markets saw a free fall and, in the process, wiped out about 40 per cent of the equity market investor’s wealth. The stock market, seen as a leading indicator of the economy, sensed that the pandemic-induced lockdown will cause a disruption in economic activity. This will have a significant influence on the economic growth of not just India, but also the entire world. To minimise the adverse impact of such a drastic slowdown in economic activity, the Reserve Bank of India and other central banks across the world flooded the system with liquidity, cut policy rates and thus decreased the cost of borrowing wherever possible so as to empower people to spend more. In truth, the tale of rate cuts in India has been pre-pandemic. When we look at the repo rates since 2018, we can observe that they have taken a downward trajectory.
As interest rates fell, individuals who invested in long-term bonds or funds that held the bulk of long-term bonds benefited on a mark-to-market basis. This can be seen in the table (Median returns (%) of debt fund category from August 2018 to May 2020) where we see most of the long duration-dedicated funds generating returns in double digits.
That said, economic recovery has made substantial headway in the recent year. As we reach the year 2022, it appears to be a true post-pandemic world with active cases dropping dramatically across the country and economic activity fast catching up to the pre-pandemic level. The side-effect of lockdown, huge stimulus and ‘V’-shaped recovery in economy is leading to higher inflation. This is posing the RBI a new difficulty in managing inflation, which was 6.07 per cent as of February 2022 – somewhat higher than the RBI’s target range of 4-6 per cent.
Inflation is an issue that affects people all throughout the world, not only in India. This was covered in our last cover story in which we highlighted our study on how one can defeat inflation. In fact, worldwide inflation is rising to the point that even nations such as China and Japan, which were thought to be in a deflationary phase, are also experiencing inflation. This has prompted some central banks across the world to consider hiking key policy rates.
In fact, United States on March 16, 2022 approved a 25 basis points rate hike and has also signaled more hikes during the year. Even various researchers in India anticipated a raise in key policy rates in the last two monetary policy meetings. However, the RBI maintained its lenient posture in order to boost growth. Meanwhile, there is much anticipation that the RBI may begin raising key policy rates in the upcoming fiscal year.
Inflation, Interest Rate and Debt Funds
The concern is that this has an influence on fixed income securities and, as a result, debt mutual funds. Debt funds are frequently seen as secure investments by investors. However, it is critical to recognise that while debt funds provide stable and regular returns than equity funds, they still face interest rate risk, which makes them volatile at times.
Looking at current inflationary environment, we would eventually be heading towards an escalating interest rate environment, which would have an impact on debt mutual funds. Bond prices are inversely related to interest rates in theory. This means that when interest rates decline, bond prices will rise. In the opposite direction, if interest rates rise, bond prices fall.
There are various categories of debt mutual funds and floating interest rate bonds are the sole exception to this rule. Bond prices are precisely proportionate to interest rates in this situation. This indicates that as interest rates rise, bond prices rise as well, and vice versa. When it comes to debt mutual funds, their net asset value (NAV) is closely tied to bond prices because they invest in bonds. As a result, any change in interest rates would have an effect on debt funds. As a result, whether you are considering investing in debt funds or currently holding them, it is critical to understand how debt funds would do in a rising interest rate environment. However, before we can comprehend how it affects debt funds, we should first grasp the current debt market condition and its prospects.
In the Indian bond and money markets, there have been two noteworthy occurrences. In the first instance, banks have gotten acclimatized to the new variable rate reverse repo (VRRR) system. As a result, both volatility and the rise in overnight deployment rates have usually subsided. Second, the market has loudly and unequivocally recognised the RBI’s categorical message on its reaction function (no line of sight on actual meaningful lift to the effective overnight rates). A combination of these factors has resulted in rather robust demand for rates up to the two-year point on the curve.
While money market rates have been under pressure recently as a result of a revised Treasury bill schedule and an increase in certificate of deposits (CDs)/commercial papers (CP) issuances, they have been easily absorbed thus far. As a result of this market behaviour, the spread between four-year and two-year government bond rates has widened to a manageable 1.10 per cent. We feel this is a more playable spread that may be viewed as offering some relative cushion to the four-year yield as opposed to the small spread of 75 basis points between the 10-year and four-year yields, which cannot be played with any degree of assurance given the massive supply of duration lined up ahead.
The Study
To understand how debt mutual funds react to increases in the repo rate, we analysed a few past occurrences when the repo rate was increased. We attempted to figure out the performance of debt funds three months previous to the increase in the repo rate, as well as three months, six months and one year following the increase in the repo rate. This will provide us a sense of how debt funds will react to a rise in the repo rate. We have taken the repo rate hikes from December 2009 to January 2014 to help you comprehend the scenario.
The three-month preceding performance from the first rate rise, which occurred on December 19, 2009, is the most crucial period in this case. The preceding table clearly demonstrates that long duration funds underperformed the most, while medium duration funds outperformed the most. Furthermore, during future rate hikes, funds holding longer duration papers, such as gilt funds, gilt with 10-year constant maturity funds and long duration funds bore the brunt of the suffering.
Only the funds holding long-term papers performed below average in the three months preceding the first rate hike, as seen in the graph above. This demonstrates that the markets discount the rate hike even before it occurs.
Although previous performance reveals what you should definitely avoid, looking at the performance after the rate hike will give you an idea of where to deposit your money. As a result, in the following paragraphs, we will examine the debt funds’ three-year, six-year and one-year performance once the repo rate is hiked.
As a result, the three-month, six-month and one-year category median returns of debt funds are depicted in the tables above. And it is evident from this that following the rate hike, gilt funds, gilt funds with a 10-year constant duration and long duration funds lost the most.
Floater funds, ultra-short duration funds and low duration funds, on the other hand, outperformed the majority of the time. Furthermore, it has been noticed that if you invest in floater funds, you will be able to enjoy their success one year later. However, in the early days of rate hikes, medium to long duration funds and medium duration funds outperformed.
One might argue that this is only one interest rate cycle. As a result, we used the most current interest rate cycle, which began in 2018. In 2018, there were just two rate increases, on June 6, 2018 and August 1, 2018. So, in the same way that we did for the period of rate hikes from 2010 to 2014, we did it for 2018 as well.
As the table and graph above show, this is comparable to what we saw in 2010. Although most funds delivered below-average returns in the three months preceding the first rate rise in 2018, long duration funds delivered negative returns. This demonstrates that history does repeat itself. However, it is more prudent to examine the performance of debt funds following the rate hike.
As seen by the three tables above, which show category median returns for three months, six months, and one year following the 2018 rate jump, after the rate hike on June 6, 2018, floater funds profited in three months, whereas long duration funds lost. This was the similar case during the period of rate hikes from 2010 to 2014. However, long duration funds performed well in the six-month and one-year periods following the second rate rise on August 1, 2018. This is owing to the fact that interest rates began to decline again in February 2019. Long-term funds performed well in the six-month and one-year periods following the last rate rise on January 28, 2014. This is attributable, once again, to the fact that interest rates began to decline in January 2015.
Conclusion
Inflation throughout the world is concerning, and India is no different. This puts a lot of pressure on central banks to keep inflation under control while still promoting economic growth. As a result, several central banks throughout the world, including the US Federal Reserve, have begun considering to raise key policy rates in order to battle inflation. However, at its most recent monetary policy meeting, the RBI maintained interest rates steady in order to encourage growth by maintaining its accommodative stance. However, it is very probable that it will begin raising the same in the near future. Rising key policy rates would cause bond prices to fall and, as a result, debt fund returns to plummet. However, our study will guide you to better understand how various debt funds react to rate hikes. Our research clearly reveals that rate hikes are bad for funds holding long-term bonds, but they are excellent for funds holding extremely short duration bonds, such as ultra-short duration funds and low duration funds, and even floater funds. That said, if your holding period is one year or less, investing in a low-duration fund together with a floater fund makes more sense, and if it is more than one year, a floater fund is a better choice because it is highly unlikely that interest rates will fall again very soon. Those searching for debt funds to devote to their financial goals, on the other hand, should invest in them based on their investment horizon. If you are an active investor, however, floater funds, low duration funds and ultra-short duration funds are the way to go right now.