The Union Budget, in plain words, is just that: the central government’s statement of inflow and expenditure for the next financial year. It is not supposed to be a life-changing event for you. Having said that, the Budget does assume significance and people look forward to it. The reason is, the finance minister may have some announcements that are relevant for us. It could be changes in personal tax rates or some other change in regulations impacting us. And, of course, the way the economy is moving, Budget measures influence many factors that impact us indirectly. This time, the Budget has nothing important on the personal tax front. However, from the overall economy perspective, there is a thrust on growth, and the equity market has reacted positively to that. The government will spend more than earlier on capital expenditure, which will create capacities for future and help develop the economy. However, the Budget proposals have not been great for the debt market. Let’s see what has happened.
In every Budget, the government projects the income and expenditure for the next financial year, and along with it, the extent of deficit. The estimates for funding the deficit are given as well. Funding of the deficit happens largely through borrowings from the market. The government issues bonds, popularly referred to as government securities (G-Secs), which are used to bridge the deficit gap. The higher the deficit, and higher the quantum of borrowing from the market, more is the supply of fresh bonds. When that happens, the interest rate that is offered on G-Secs goes up as buyers have to be induced to buy them. In the process, interest rates prevailing in the market go up as well.
Bond prices and interest rates move inversely; when interest rates move up, bond prices come down, and vice-versa. How does that impact you? If you have existing investments in debt mutual funds, the units get valued at the daily net asset value (NAV), which is calculated according to the prevailing prices of the instruments (which can be equity or debt) in the market.
When you refer to your portfolio statements, your debt mutual funds will show relatively lower returns. Hence, interest rates going up is not good for your existing debt mutual fund investments. However, it must be noted that this is not a loss per se as it is just a valuation on paper; if you redeem your fund at the relatively lower NAV, you are making the ‘paper loss’ a real one. If you hold on to your debt mutual fund investments over an adequate time horizon, things will recover gradually.
Expectation Versus Announcements
Coming to the Union Budget presented on February 1, 2022, the fiscal deficit that the finance minister projected, and more important from the debt market perspective, the gross borrowing from the market, was on the higher side. The projected gross borrowing for 2022-23 is projected at Rs 14.95 lakh crore, whereas the market was expecting something lower in the range of Rs 12.5-13 lakh crore.
There are two reasons for the differential between expectation and budget proposal: (a) the tax growth estimates in FY2022-23 are conservative because, while usually the government overestimates the tax growth, this time they are under-estimating; and (b) the contribution from the other source of funding the deficit—Small Savings Schemes (Post Office)—is also projected in a conservative manner. Net-net, the borrowing from the debt market is much higher than the expectation.
Moreover, the market was expecting some coverage in the Budget speech that would enthuse foreign portfolio investors (FPIs) to invest in India. There are talks of inclusion of G-Secs in global bond indices, which would lead to buoyant investments in debt by FPIs. While inclusion in global bond indices is a matter of time, as part of the efforts in that direction, G-Secs should preferably be listed in a system called Euroclear Exchange, and for that, there is an expectation of giving tax exemption to FPIs. It was expected that the Budget would announce tax exemptions for FPI investments in debt. That is not happening for the time being, as announced in the post-Budget media conference. Net-net, inclusion in global bond indices, and inflows from there, has been pushed back.
What’s The Fallout?
Bond yields have moved up, as there would be more fresh supply of bonds as mentioned earlier, and no signs of a fresh bond buyer in the form of higher FPI investments. Going forward, the Reserve Bank of India (RBI) is set to start the rate hike cycle. In the face of a larger projected fiscal deficit, RBI may be a little apprehensive, but ultimately it will have to hike interest rates. The impact on the NAV of your existing debt fund investments would be adverse. So what should you do in this situation? The method that most investors are folllowing is to shift from debt funds with long portfolio maturity to ones with relatively short portfolio maturity. Shorter the portfolio maturity of the fund, the lesser is the volatility due to interest rates moving up in the market. By playing defensive in this phase of the market, you would be reducing the adverse impact of interest rate moving up, either due to higher borrowing by the government or potential rate increases by RBI.
Higher interest rates are good for fresh investments, as you are buying into a fund at a lower NAV and when things improve, you will gain that much more.
What You Can Do
In your overall portfolio, equity is the more volatile component. Debt mutual funds are less volatile than equity funds, but these are not like a bank fixed deposit. As mentioned earlier, if you have an adequately long investment horizon, things will get sorted on its own. Otherwise, if you want to be proactive or do not have a long time horizon, you may shift to funds with relatively shorter portfolio maturity. The ballpark guidance is, you may match your time horizon with the portfolio maturity of the fund.
The writer is a corporate trainer and author