Debt Mutual Funds have borne the brunt of RBI’s change in its policy stance from accommodative to neutral on the 8th of February 2017. The change in policy stance negatively surprised the bond market with government bond yields and corporate bond yields rising across the curve. Table 1 gives the change in bond yields and money market securities yields post policy.
As we can see from the Table, the sharpest rise was seen in the 10 years to 30 years maturity gsec, with yields rising by 45bps to 55bps. Corporate bond yields rose by 17bps to 25bps across the curve while money market securities yields rose by just 10bps to 15bps.
Given the rise in bond yields, Debt MF’s too saw fall in NAV’s with gilt funds being affected the most and income funds being affected the least. Money market funds were not affected at all.
What is the Right Debt MF for you post RBI Policy, with yields on the higher side. The first question to ask yourself is what returns can i get from Debt MF’s if yields are stable. Looking at Table 1, one year returns can broadly mirror the bond yields, less expenses.
Money market funds returns – 6.25%
Ultra Short Funds- 7%
Short Term Income Funds – 7.25%
Long Term Income Funds – 7.5%
Long Term Gilt Funds – 7.10%
Credit Funds – 8.5% to 9%
The next question you should ask yourself is whether bond yields will move up or down. Given that yields have backed up sharply and RBI has just changed stance and is more likely to keep rates on hold for a while, bond yields should be fairly stable at current levels. However, immediately there are risks in the form of Fed rate hikes, rise in US treasury yields and start of government borrowing in April. The first half government borrowing will be heavy due to bond maturities of Rs 1.74 trillion and with banks running excess government securities of almost 7% over statutory limits of 20.5% of NDTL, concerns that banks may not buy government bonds are there.
Given the immediate risks, long term gilt and income fund investments can be put on hold.
Short term income funds offer reasonable returns of 7.25%, which is 1% over liquid funds and risk to the shorter end of the curve is low as RBI is holding rates and the system is flushed with funds on demonetization. These funds can substitute fixed deposits over a 3 year period as banks are lowering deposit rates.
Credit funds carry credit risk but offer higher returns of 8.5% to 9%, which is a risk worth taking as an improving economy will lead to healthier corporate balance sheets.
Liquid and ultra short funds offer lower returns but risk is extremely low. You can use these funds to park temporary cash and move in to other Debt funds when time is right.
You can time your investments as well by waiting till March where state election results will be out and Fed would have finished its March meeting (14th & 15th of March).
RBI, Fed and Bond Markets
On 8th February 2017, the monetary policy committee of the Reserve Bank of India against consensus expectations not only decided to hold rates but also changed the monetary stance to neutral from accommodative.
This was the second time that the tightlipped Governor Urjit Patel led MPC surprised markets.
Earlier on the Dec 6th 2016 policy which was post the November 8th demonetisation of 86% of currency in circulation, they chose to hold rates. Both the times the decision of the committee was unanimous.
Clearly there is a disconnect between the assessment and the reading of economic data and the priorites of the MPC & the RBI and what the market had perceived to be the way forward.
The MPC completely brushed aside any concerns on growth due to the demonetisation shock and have chosen to focus on possibilities of inflation resurfacing. The reasons cited then were a possibility of rising core inflation due to surge in oil and commodities prices, imminent US Fed rate hikes and uncertainty of the policies of Donald Trumps administration.
The Reserve Bank of India has a medium target of inflation of 4% +- 2% on the upside or downside and they expect inflation to be at 5% in 2018. Post the policy the perception seems to be that the current Governor and the MPC is fixated on 4% inflation instead of a 4+- 2%.
Debt market participants would have nonchalantly taken a no cut in its stride and moved ahead had it been just that. But the change in stance devastated them and yields rose up before investors could blink. 10 year yields rose by 45 bps.
When the regulator gives a signal that the easing cycle is over and they may in fact raise rates to curb raising inflation traders and investors in bonds react violently. This is because they believe that bond prices are overvalued and they will fall to align with higher interest rates. That is why the rush to sell bonds.
Senior bankers, observers and analysts unequivocally endorsed the cautious demeanour of the monetary policy post the event. Not many had advocated a change a stance but some had supported a hold of rates.Many believe that RBI acted in haste when turning policy neutral.
As events post the policy progressed, December 2016 IIP numbers have reported a fall of 0.4%. The de growth may be transient due to demonetisation and can bounce back quickly.
January CPI eased to a 5 year low of 3.17% mainly due to falling vegetable and pulses prices. The WPI rose to 5.25%, a 30 month high, against 3.39% in December 2016. The rise in WPI was mainly on account of power and fuel prices.
RBI hold of rates was vindicated somewhat as core inflation rose and is sticky at 5.2%.
In the US Janet Yellen the Fed Chair said that US growth and inflation if on track as per expectations then the Fed will move to hike rates. 10 year US Treasury yield, which has seen a steady climb from a low of 1.37% is currently trading at 2.5%. Expectations are that it will see a steady climb close to 3%.
Against a changed RBI policy stance and imminent Fed rate hike, fixed income mutual fund investors have got caught unawares.