Is it the right time to invest in debt funds?

Higher interest rates have also driven yields higher, causing debt funds to underperform. Is it, the correct moment to accumulate debt fund units? Let's find out.

Debt Funds have not had a great year so far. The spate of interest rate rises in 2022 elevated bond yields while lowering debt fund returns. Even though inflation was approaching 7 per cent, most debt fund categories posted returns of less than 5 per cent. 

However, the tide appears to be changing in favour of debt. They appear enticing right now due to increased returns in the face of continuously rising inflation and higher interest rates in the coming years. There are signs that the interest rate cycle is reaching its top, with just a little increase projected at the Reserve Bank of India's (RBI) next review meeting in February 2023. 

Given the enormous frontloading of monetary policy tightening and the vulnerability of economic development, the RBI should reduce or perhaps halt rate rises. Most experts believe that debt funds will provide good returns in the coming months. 

High bond yields present an excellent chance for investors to lock in at current prices. The prognosis for debt funds is favourable. Within the next 1.5 years, debt funds should do pretty nicely. 

Investors should progressively raise their exposure to debt schemes. In the last year, the yield to maturity (YTM) of all types of debt funds has increased dramatically and is now above 7 per cent. However, in open-ended debt mutual funds, YTMs and actual returns do not necessarily match owing to portfolio churn caused by inflows, outflows, and other factors such as changes in ratings and interest rates. 

Debt funds should be considered for reasons other than their present higher yields. These funds also provide various other advantages in terms of liquidity, security, and simplicity. Short-term rates increased dramatically in 2022 and have continued to grow, but long-term yields have risen since June, flattening the yield curve. 

The term spread, or the difference between the yield on a 10-year bond and the yield on a 3-month Treasury bill, decreased from 3.1 per cent in May to 0.93 per cent in December. Short-term rates have risen as a result of the RBI's rate hikes and constrained banking liquidity. 

The repo rate increased by 35 basis points most recently, making it the fifth rate increase this fiscal year. The repo rate has risen by 225 basis points since May 2022, and it now stands at 6.25 per cent. 

In addition, consumer inflation dropped to an 11-month low of 5.88 per cent in November. Retail inflation has gone below the RBI's upper tolerance limit for the first time in 2022. This might also imply that the RBI will take an extended break from raising interest rates following the February 2023 policy review. 

However, the RBI was more hawkish than predicted in its December 2022 policy review and has maintained its stance on accommodation withdrawal. Long-term rates have been stable as the 10-year bond yield has trailed behind short-term bond yields as CPI inflation has slowed, pension funds have strengthened their demand for long-dated bonds, and crude oil prices have fallen. 

The 10-year yield has dropped by more than 31 basis points since reaching a high of 7.61 per cent in June, and it now sits at 7.29 per cent. Long-term bond yields are projected to remain range-bound as inflation in India and the United States moderates, oil prices decrease, and government finances improve. 

However, factors like the Federal Reserve's quicker rate-hiking pace, mounting pressure on the rupee, a signal of a higher repo terminal rate, or inflation shocks might contribute to a future surge in long-term rates.