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RBI holds rates steady: What should debt fund, fixed income investors do

The first bi-monthly monetary policy for fiscal 2022 kept a status quo on all key policy rates. The Monetary Policy Committee (MPC) of the RBI also reiterated an â€œaccommodative stanceâ€ on rates and â€œsurplus liquidityâ€ to help the economy return to a durable growth path. In this backdrop, what should fixed income and debt fund investors do? Here is a low-down.
Positive for long end tenor
Key measures include a quarter wise OMO calendar, that should help manage the yield curve and the massive borrowing program, with INR 1 trillion scheduled in Q1-FY 22. RBI expects inflation to rise marginally in FY 22 though expects food inflation to soften. “The policy is supportive of long end rates, with some impact at the shorter end owing to longer tenor liquidity absorptions as part of the liquidity management program. We would continue focusing on Banking & PSU, Corporate Bond and Dynamic Bond fund categories, post todayâ€™s policy, ” says Kumaresh Ramakrishnan, CIO-Fixed Income, PGIM India Mutual Fund.
Corp bond spreads remain moderate
Interest rates are likely to remain range bound going forward as RBI is committed to ensure easy liquidity and low repo rates. The increase in Government borrowings are likely to be partially offset by RBI OMOs and secondary market purchases of Government securities. Inclusion of government securities global bond indices will add to the demand.
“Corporate bond spreads are likely to remain at moderate levels on back of restrained supply and continued demand from institutional investors. Unless inflation expectations start increasing in the future, fixed income investors will do well to remain invested in Indian bonds,” says Sandeep Bagla, CEO, TRUST Mutual Fund.
Dynamic for higher risk takers
RBI’s concerns over inflation was clearly reflected in the governor’s statement. This along with the fact that the RBI has given up on the time based forward guidance to keep monetary policy accommodative, indicate that course of monetary policy could change sooner than expected.
Says Pankaj Pathak – Fund Manager – Fixed Income, Quantum Mutual Fund: “We expect that the RBI could start hiking policy rates towards end of this year. On the other hand the commitment to buy government bond under the GSAP is a good move to support the long term bond yield. this will support long term bond yields in near term. But medium term trajectory will depend more on the policy outlook.”
Pathak feels investors should expect gradual rise in bond yields over medium term We also expect very high volatility in interest rate going forward, he added.
Dynamic bond funds could be an option for investors with long time horizon and higher risk appetite. Conservative investors should stick to liquid funds.

Low single-digit returns

“Todayâ€™s RBI policy has reiterated our earlier view that investors should expect low single-digit return from the bond market in FY22 and will have to increase their average maturity in order to optimize their risk-adjusted returns. We wish to highlight that investors at the short-end (up to 2Y) will probably earn
zero or negative real return (inflation-adjusted) in FY22, similar to FY21,” says Dhawal Dalal, CIO-Fixed Income, Edelweiss Asset Management.

Prudent investors are requested to consider investing in high-quality bonds maturing in 5Y or higher through passively-managed target-maturity bond index funds as well as bond ETFs to benefit from diversification, transparency, simple & clear investment objectives and predictability of returns for hold-to-maturity investors in our opinion, Dhawal added.

The move to introduce G-SAP â€“ secondary market GSec acquisition program is a master stroke by the RBI, said many experts. This would reign in sharp spike in GSec bond yields. Introduction of long term VRRR (variable rate reverse repo) is an extension towards normalising liquidity. “Liquidity surplus however will and is likely continue. We expect yield curve to flatten from the current levels with the longer end of the yield curve compressing faster than the short end,” says Lakshmi Iyer, CIO (Debt) & Head Products, Kotak Mutual Fund.

“…with these measures, RBI measures should be able to counter the global adverse backdrop of upward movement in yields and higher commodity prices. The increase in Long term repo operations over 15 days could see the upto one year yields moving up by 10 to 15 basis points and remaining at that level,” feels Murthy Nagarajan, Head-Fixed Income, Tata Mutual Fund.

Rising bond yields: What it means for equity, debt investors

Indian financial markets and global financial markets right now have something in common: rising yields. By the end of third week of February, the average increase in India’s G-Sec yields across 3,5 & 10 years was around 31 basis points since the Union Budget on concerns of the market borrowing plans of the government. Things haven’t improved much. Currently, the 10-year G-Sec yield is now ruling at 6.25 per cent.

On the other hand, US yields have risen too. The 10-year US treasury yield has increased to nearly 1.5 per cent from 0.7 per cent six months ago, creating fear in the minds of investors across the globe. In this context, it is important for investors to understand how to read these changes for debt and equity investments.

Understanding rising yields

Simply put, rising yields on bonds means that bond prices are falling.

India’s G-Sec yields are not softening in a hurry. Research firm AcuitÃ© Ratings & Research expects Indiaâ€™s 10-year sovereign yield to rise to 6.40 per cent by March 2022.

From a classical economics standpoint, the rise in bond yields hikes up the cost of capital for companies. When the cost of capital rises for a company, it can affect earnings and, by extension, its valuations.

One thing is clear. Global and local central banks have kept interest rates low for long. So, the increase in yield is in-line with some normalisation that eventually had to happen.

Whenever the bond yield increases, investors are likely to withdraw from equities and look at bonds, who are offering higher money at lower risk.

Indian context

Yet, it is also true that some investors are panicking too much on account of the rising yields. Rising yields is not necessarily a very bad thing. The global rise in yields does not mean a ‘sell call’ on equities.

In the US, the key premise on which bond yields are rising or rather normalising to pre-Covid levels is that US economic recovery will be faster than earlier envisaged resulting in rising inflation. Is US and Indian economic recovery bad for equities? No!

“In our view, equities as an asset class perform better in an environment of â€˜rising growthâ€™ and â€˜moderate inflationâ€™. For example, despite the rise in Indian bond yields from ~5 per cent to 9 per cent and US yields from 3.5 per cent to 5 per cent from 2003 – 2007 as demand-led inflation picked up, global stock markets including India had their best run as growth kept surprising on the upside,” says ICICI Securities.

However, do keep a close watch on the situation. You can take a negative stance when the environment has rising yields and slowing growth or stagflation. This happened in the 2012-2013 period when India GDP growth dipped to ~5 per cent while yields climbed to 9 per cent, coinciding with the taper tantrum. This is the worst environment for stocks.

How to play debt funds

Enough of explanation for equities, let us look at debt – specifically debt funds. The fundamental characteristic of your debt fundâ€™s return is guided by yields. As yields move up the prices of bonds fall. This fall is sharper in longer duration bonds and slower in lower duration bonds.

But if yields move up, the fall in bond prices will be inevitable. So, when yield moves up, there can be losses in debt funds. When the yield up move is gradual, the fall in returns will be gentle. When the yield jump is sharp, the fall in debt fund returns will be sharp.

Do note that debt funds with longer duration are more sensitive than the ones with shorter duration.
The yield impact on debt funds’ existing investments will be progressively lower as and when the funds start buying bonds with higher coupon rate.

Note: If you would like to know what should be your portfolio strategy in an environment of rising yields, connect with the experts at Wealthzi.

5 reasons why debt funds are better than fixed deposits

Fixed deposits offered by banks in India are paying interest rates of around 3% to 5.5% for a year. This is very low when compared to a few years ago when these bank deposits gave investors more than 9%. Do you know that debt mutual funds can provide you with returns of more than 7%? This is one of the reasons why debt mutual funds score over fixed deposits. There are many other benefits to investing in debt mutual funds.

Higher earnings

Debt funds gain when there is an increase in the value of bonds in the fundâ€™s portfolio. This happens when interest rates fall. When interest rates rise, the mutual fund will reinvest the proceeds from maturing bonds at higher rates. This is how debt funds are able to provide good returns to investors in any scenario. If you had invested in a well-performing banking and PSU debt fund for five years, you would have earned around 8% while a five-year deposit would have earned just 6.9%.

Better taxation

The post-tax returns on fixed deposits are very low as the interest from this investment will be taxed as per your tax bracket. For instance, if you invest in a deposit that earns 5.5%, your post tax returns will be 3.8% if you are in the highest tax bracket. This is where debt funds can provide investors with higher returns.

The difference in post-tax returns from debt funds will be much higher as the long-term capital gains tax rate is just 20% plus indexation benefits. You can get the indexation benefit on gains from debt funds that have been held for more than 36 months. The cost of acquisition of your investment will be revised as per inflation and this notionally brings down the taxable capital gains. So, your tax liability is reduced. In comparison, interest earned on bank deposits will be taxed at the investorâ€™s income tax slab bracket.

Liquidity

Unlike bank fixed deposits, there is no penalty for withdrawing your money from open-ended debt funds. You can withdraw money any time you want. For a bank deposit, around 1% of your return will need to be paid as penalty if you exit the deposit prematurely. Exit loads on short- and medium-duration funds will be applicable only if the withdrawal is made within a year of investing. Most debt funds have no exit loads. Debt funds also allow you to regularly withdraw from the funds if you want regular income.

Variety of schemes

Most advisors suggest that clients try to match the debt fundâ€™s duration to the investorâ€™s financial goals, time horizon and risk profile. Since different funds have different durations ranging from overnight funds to long term debt fund with 10 years duration, you can easily choose ones that are right for your goals.

Note that debt funds come with risks. However, you have the flexibility to decide what type of risk you want to take. You can choose shorter term funds if you donâ€™t want to take much risks. For instance, banking and PSU debts are considered to have credit profile that is of a bank deposit. So, you can choose from various funds that are right for your goals.

Portfolio diversification

Most debt funds invest in a diversified portfolio. So, portfolio exposure to a single security that may be downgraded is minimised. Default risks are also reduced. For instance, in the case of the DHFL default, the exposure of open-ended funds to the security from this company was typically below 5%.

Unlike debt funds, bank deposits come with high concentration risks because investors hold large sums of money in one bank and run the risk of losing it all if things go wrong with the bank. There is very little information available to investors in case a bank goes bankrupt. They have very few options for exit or redressal. Thatâ€™s why open-ended debt funds score higher. Open-ended funds are required to provide regular information to investors on the fundâ€™s portfolio and performance.

So, debt funds are better than fixed deposits. However, you need to select well-managed funds that have performed consistently and make sure that the portfolio is a well-diversified portfolio. If a fund is taking too many concentrated bets or has more credit risk than its peers, you shouldnâ€™t invest in the fund. Reviewing the fund once a year is a good way to stay invested in good funds.

How to reinvest your income from investments

Fixed deposit is a very conservative financial product and is preferred by mostly senior citizens as it is considered safe. The elderly view deposits as a long-term investment and on an average commit their money for three to five years. Now that fixed deposit interest rates have fallen, many feel that there is a need to earn more money.

There is another category of investors that invests in mutual funds and opt for dividends. Most of the times, the salaried who opt for this and receive dividends from mutual funds don’t use them. The money is kept idle in their savings account.

Both these categories of investors can reinvest their income to earn more money.

There are several options available for such reinvestment. However, only some come with ease of liquidity as well as good returns. For instance, you can invest the interest from your deposit in the National Savings Certificate (NSC) or the Public Provident Fund (PPF). Both these investments provide tax benefits under section 80(C) of the Income Tax Act but your money will get locked in for many years. That’s why you need to carefully choose the investments based on your financial needs, risk profile and other related factors. Here are some options you can consider.

If you are getting a monthly pay-out

If you are not going to use the interest on your deposit and it is lying idle in your savings account, consider investing in the following options for better returns.

Bank Recurring Deposit

Choose from the Recurring Deposit schemes offered by your bank where you hold your saving account. For instance, you had invested Rs. 4,00,000 in a deposit for 10 years at the interest rate of 9%, you will be getting a monthly interest of Rs. 4,000. You can reinvest this income to earn more by putting it in a Recurring Deposit.

If you invest Rs. 750 from your interest income in a Recurring Deposit for five years, you will be receiving Rs. 54,735 on maturity. This is assuming that you invest at the interest rate of 7.5% for ever year. How is this an advantage? If you had let that amount be in your saving account, you will earn only Rs. 4,500 as interest in five years if the savings account interest rate is 4%. However, if you invest it in a Recurring Deposit, you will have earned an interest of Rs. 9,600.

Here are the advantages and disadvantages of investing in a Recurring Deposit.

One of the main advantages is that you get the same interest rate as your fixed deposit. The rate will be higher for senior citizens. You can invest a fixed amount every month, ensuring discipline. You can choose to invest for either short term or long-term goals as the tenure for Recurring Deposit is between six months and 10 years. You can get loan as an overdraft facility for your Recurring Deposit. The best part is that there is no Tax Deducted at Source (TDS).

The only disadvantage with Recurring Deposit is that you can get no tax benefits.

If you are getting an annual pay-out

Corporate deposits

If you are receiving an annual income from your investments, you can consider investing the income in a corporate deposit. You can choose from one year, two-year, three year and five-year corporate deposits. You can even ladder your investments by investing every year. For instance, you had invested in a 10-year deposit that gives you interest at 9% and you are receiving Rs. 9,300 as interest. If you invest this income in a one-year corporate deposit that gives you the same interest rate and keep laddering the investments for five years, you will have earned an interest of Rs. 5,000 at the end of five years. Note that as long as you invest in rated corporate deposits, the risks are lower. Laddering helps you review the deposit every year and you can choose to reinvest the maturity amount in better options at the end of every year.

The main advantage of corporate deposit is that you get a higher interest rate when compared to fixed deposits and Recurring Deposits. You could even getachoice of monthly, quarterly, half yearly and annual interest payouts for your corporate deposit. Another advantage is that there will be no TDS for your deposit if interest earned is less than Rs. 5,000.

The main disadvantages of corporate deposits include no tax benefits. The ease of getting your money back is much lesser when compared to bank fixed deposits. Another disadvantage is that there is higher credit risk involved. You may need to keep track of the deposit ratings and the company’s performance.

Mutual funds

Investing in mutual funds can help you overcome the disadvantages of corporate deposits. You can invest your income using SIP or a lumpsum in direct mutual funds. Equity mutual funds can give you returns that beat inflation.

Here’s a table that will help you understand how much you can save by reinvesting your income from investments.

Pre-tax returns

Amount reinvested	Investment used	Interest rate on the reinvestment	Maturity amount
Rs. 750 per month	Recurring Deposit	7.5%	Rs. 54,735
Rs. 9,300 per year	Corporate deposit	9%	Rs. 60,664
Rs. 9,300 per year	Mutual fund	12%	Rs. 66,172

Note that for the investments made, the tenure is assumed to be five years and compounding for Recurring Deposit and corporate deposit will be quarterly.

If you need help with managing your wealth portfolio, contact wealth team at Wealthzi.com

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