Debt Fund Strategy Post MPC: Stick With Shorter Maturity, Avoid Long-Term Funds

The Reserve Bank of India’s (RBI’s) Monetary Policy Committee (MPC) on February 10 left the key rates unchanged and persisted with its accommodative stance. The MPC maintained the repo rate (the rate at which the RBI lends short-term funds to banks) at 4 per cent and reverse repo rate (the rate at which the banks park their funds with RBI) at 3.35 per cent. RBI has left the key rate unchanged mainly because of its view that ongoing domestic recovery is still incomplete and needs continued policy support. Moreover, the inflation projection is close to the upper tolerance limit of 6 per cent.  

However, experts believe that RBI will change its stance and hike rates, which means investors’ debt strategy now should be to focus on lower duration profiles and lock in at incrementally higher rates over the next 6-12 months. Here’s what you can do and the factors that will influence your investments. 

Inflation Under Control 

The central bank noted that core inflation continues to remain at tolerance testing level but demand-pull pressure remains muted. It expects the financial year (FY) 2023 Consumer Price index (CPI) to moderate to 4.5 per cent on the back of fresh crops, supply side intervention by the government on edible oil, and a waning base effect. Notably, RBI’s target is to keep inflation in a band of 2-6 per cent. 

As a result, the central bank will continue to remain supportive to aid economic growth in the coming quarters. Accordingly, it is almost certain that there is not going to be any rate hike soon.  

Moreover, higher crude oil prices are looming. So, any hike in policy rates will be gradual and orderly to avoid any major disruption, though the central bank has not given any direction on the same.  

“Given that the government has assumed the mantle of supporting and reviving growth, the RBI needs to prioritise financial stability and inflation. The RBI would have been better off guiding on how they would normalise liquidity and interest rates in the coming months,” says Arvind Chari, chief investment officer, Quantum Advisors.  

Yield Stabilising 

In an environment where global central bankers are rushing to raise interest rates across much of the developed world and in a few emerging markets, the RBI’s action yesterday stands out. The status quo of monetary policy and the RBI governor’s dovish statement surprised the debt markets.  

Yields fell by 10-15 basis points (bps) post the monetary policy announcement. Yields were elevated after the Budget announcement of higher borrowing by the government. “Market yields have taken support from the cancellation of auction as announced by RBI earlier this week and now this dovish stance by RBI will mean that yields remain largely stable till March 2022. We expect the curve to remain steep, with the shorter end of the curve outperforming the longer end,” says Puneet Pal, head-fixed income, PGIM India Mutual Fund. 

Stick With Short Term Debt Fund 

Experts believe that RBI will change its stance, going forward, and increase the policy rates. “We continue to maintain that the RBI will move its policy stance to neutral. It will move the operational policy rate to the repo rate. And it will hike the repo rate by 100 bps by March 2023,” says Chari. 

Therefore, investors looking to allocate to debt strategies are advised to look at fund segments with lower duration profiles and use target maturity strategies to gradually lock in incrementally higher rates over the next 6-12 months. “Bond yields are likely to see increased volatility and hence, investors should remain vigilant in their allocations,” advises Axis Mutual Fund in its post-monetary policy review report. 

Why Not Long-Term Debt Funds? 

Why should investors focus on short-term and not long-term debt funds, when the latter have delivered better returns in the past?  

It is true that long-term debt funds are known to provide better returns, but at the cost of higher volatility. Short-term funds show greater stability in returns compared to, say, income funds, which are more volatile as they invest mostly in longer-tenure papers. If you are invested entirely in income funds and need to sell when they are down, you might not realise the best price for your investment. 

Overall, “yields are likely to trade with an upward bias given the demand supply imbalance of market borrowings. Further, gradual normalisation of monetary policy is also likely to put upward pressure on yields, especially at the shorter end. In view of the aforesaid and relatively steep yield curve, we continue to recommend investments in short to medium duration debt funds, possibly, in a staggered manner in line with individual risk appetite,” suggests HDFC Mutual Fund in its policy review report.