Risk averse investors may switch to short term debt funds

Debt mutual fund investors face credit risk, liquidity risk and interest rate risk in their portfolio. The first two have gone into the backburner for now. On the credit risk front, it appears that most of the skeletons have come out of the cupboard, starting from ILFS. With RBI infusing lakhs of crores of liquidity into the system to counter the effect of the pandemic, liquidity risk is also not a concern now.

The biggest cause of worry for debt fund investors is no longer risk of default (credit risk), but risk on account of rising interest rates. Bond prices and yields/interest rates move in the opposite direction, and an increase in interest rates, leads to fall in bond prices.

The interest rate cycle has bottomed out


The pandemic resulted in central banks globally and in India, unleashing massive liquidity and cutting interest rates. RBI’s measures like the Targeted Long Term Repo Operations, open market purchases, Government Securities Acquisition Program(G-SAP) and its intervention in FX markets, has led to surplus liquidity of about Rs 10 lakh crores in the system, accompanied by a 115-basis points reduction in the policy repo rate by the Monetary Policy Committee.

Many past investors in long duration funds have therefore made windfall returns in double digits in a scenario where banks have been offering a meagre 5% on fixed deposits.

All good things have to come to an end!

The supply chain disruption on account of subsequent waves of the Corona virus and excess liquidity in the system has resulted in a spike in commodity prices and consequent inflation. When it comes to bond market yields, inflation is anathema. The largest and most liquid market in the world, the US Treasury market, has shrugged off concerns about multi decade high inflation. But the story has been different for emerging markets like India. The benchmark 10-year government securities (G-sec) yield at less than 6% until a few months back, has crept up steadily to around 6.24% in the face of rising inflation.

Tussle between RBI and bond market investors

RBI in its role as debt manager/Investment Banker to the Government of India manages the Government’s market borrowings to help finance the fiscal deficit, through issuance of government securities (G secs). A rise in bond market yields would result in higher interest payments on the G secs, further stretching the Government’s finances. Moreover, yields on G-secs act as the benchmark for the interest costs in the economy; low interest rates are crucial to revive growth. Therefore, RBI has every incentive to keep market yields low, despite the deleterious effect on inflation. Central banks in India and in the US have dismissed current high rates of inflation as “transitory”.

Unfortunately, bond market investors think otherwise, in India. When RBI tries to sells G-secs through its bidding process, the would-be investors, in the face of rising inflationary trends, have been demanding a yield higher than the RBI’s comfort zone, though there is no official G-sec rate target. This has resulted in some of these bids from investors being rejected. But RBI has to come back to the market to meet the Government’s borrowing requirement. To curb rising yield expectations in the markets, the RBI has been buying G-secs from the markets through the G-SAP program. However, the size of the G-SAP is not commensurate with the Rs 12 lakh crore borrowing requirement, nor is it intended to be.

Faced with a deluge of G-sec issuance and rising inflation, the tussle between bond market “vigilantes” and RBI has been playing out in the form of a slow but steady rise in G-sec yields. The overhang of the tremendous liquidity infused in the system, through various measures of RBI as well as through RBI’s intervention in FX markets through US Dollar purchases, has kept bond yields from rising very sharply until now.

Many factors can break this logjam between the markets and RBI, including further rise in inflation/commodity prices, increase in G-sec supply, and change in India/US monetary policy stance. These moves can lead to a blowout increase in G-sec yields.

Outlook for debt mutual fund investors

A high duration in their debt fund exposes investors to significant losses, in the catastrophic scenario of a steep increase in bond yields, as witnessed during the 2013 “taper tantrum” phase.

Investors who have a portfolio of longer duration debt mutual funds, may consider switching a part of their holding to shorter duration funds, while keeping in mind that any such switch before a three-year holding period may lead to loss of indexation benefit and a higher tax rate.

Investors should also be mindful of the fact that the prevailing yields in lower duration funds are paltry, and after adjusted for inflation, negative. Many debt funds with 1-year duration are yielding about 4-4.5% while 2-year duration funds have yields of about 4.5-5% after expenses.

Such negative real yields (nominal yields less inflation of 5.6% currently) have driven many retail investors to the stock markets. Central banks liquidity in trillions of Dollars in the US and in lakhs of crores in India have resulted in today’s bull markets. The tide may turn when central banks withdraw the liquidity. Fearing the impact on the financial markets, central banks globally have been wary of doing this and in the process exhibiting a “slavish” attitude to the markets. Already there are dissenting voices among monetary policy makers, though now in a minority, on central banks keeping the markets on steroids through liquidity, and risking inflation in the process. When the minority becomes the majority, the markets may witness sharp corrections, though no one can forecast when this will happen.

Meanwhile, in the face of these uncertainties, risk averse debt mutual fund investors may switch out their long duration funds into short duration ones and invest any incremental funds too, in such short duration funds.

(The author is an expert in corporate banking and fixed income investing.)