Testing Times For Debt Fund Investors

In this wildly swinging, unpredictable market scenario, the usually bankable debt funds have also turned volatile. However, investors should remain invested to ride out this phase, advises Hemant Rustagi

The equity markets have been volatile for the last few years, and this reflects in the performance of equity funds. The incessant bouts of volatility as well as the not-so-impressive returns have been testing the patience and resolve of investors.

While investors have been trying to grapple with the stock market’s volatility, the softening interest and resultant impressive performance of debt funds have helped in soothing their nerves to some extent. As there is an inverse relationship between interest rates and bond prices, a variety of funds like short-term income funds, dynamic bond funds and medium-term income funds performed well.

Unfortunately, even the debt markets turned volatile in June 2013 when, despite a fall in WPI inflation, the RBI did not cut the key rates in its credit policy. The RBI decided to maintain status quo on account of high Current Account Deficit (CAD) and movement in the exchange rate. The US Fed’s decision to roll back its USD 85 billion bond purchases also created panic in markets across the globe. The situation become even more tenuous as the rupee touched an all-time low vis-a-vis the USD.

To save the day, the RBI swung into action and fixed the borrowing limit of banks at one per cent of the system’s net demand and time liability or the banks’ total deposit base w.e.f. July 17, 2013. Besides, the Marginal Standing Facility (MSF) rate and the bank rate were raised by 200 basis points to 10.25 per cent. The central bank also announced a sale of Rs 12000 crore government bonds to squeeze liquidity.

These steps had an immediate and serious impact on the debt markets. The yield on 10-year benchmark government securities rose to 8.12 per cent from the previous close of 7.58 per cent. Consequently, the NAVs of all types of debt funds were negatively impacted. Since the major differentiator between different types of debt funds is their portfolio maturity duration, the impact varied depending upon this factor. For example, the fall in the NAVs of medium-term income funds as well as dynamic bond funds was much more than those of short-term and ultra short-term income funds.

Needless to say, the RBI’s action and the reaction on debt investments created panic amongst investors. The most strongly impacted were those investors who began investing in income funds over the last six months based on the last one year’s performance and with an expectation that the debt market rally will continue.

A situation like this can undoubtedly unnerve even the most seasoned of investors. However, it is important for them not to panic and to avoid taking hasty decisions. Instead, they would do well to tone down their expectations in terms of returns, stay invested for 15-18 months and be prepared to face bouts of volatility.

The general consensus is that the RBI’s measures are short-term in nature and are likely to be reversed as soon the rupee stabilises. In its credit policy review on July 31, 2013, the apex bank also indicated that liquidity tightening measures will be rolled back in a calibrated manner if the currency stabilises.

Maintaining a cautious stance, the bank cut the GDP growth forecast for FY14 to 5.5 per cent from the previous 5.7 per cent. The RBI also urged the government to take immediate steps to narrow the CAD, which hurt the rupee as well as overall growth. It is evident that once the rupee stabilises, the monetary policy will revert to supporting growth with a continuing vigil on inflation.

Though the current macroeconomic situation may have delayed the rate cut, it has not been completely ruled out. Given the subdued economic growth and the moderation in inflation, a 50 basis points cut can be expected over the next 12 months.

Considering that short-term rates have risen sharply, Fixed Maturity Plans (FMPs) have emerged as a great investment option for investors who are looking to make fresh investments without any volatility risks. In the open-ended category, short-term income funds as well as accrual funds can be considered. Accrual funds are those that focus on accrual of income as well limit volatility and follow a buy-and-hold strategy. For those who do not mind facing some volatility risk to get a chance to earn higher returns, dynamic bond funds work well.

Hemant Rustagi
CEO, Wiseinvest Advisors