There are expectations that Reserve Bank of India (RBI) will cut interest rates in 2024, following the US and Euro zone rate cycle reversal
Returns in debt funds come from two avenues. One, accrual which means the coupon or interest that accrues on the instruments in the portfolio. Two, prices of the bonds and/or other instruments that move up or down in the market. The accrual, which is accounted in the net asset value (NAV) every day, is a given. It happens without any conditionality; it happens irrespective of market conditions. It is the market movement that adds to it (if bond prices move higher) or takes away (if bond prices move lower) to the daily accrual in the portfolio.
Recap: 2021 And 2022
These two years were marked by yield levels in the market moving up. Bond yields and prices move inversely, and hence market-related components were impacted adversely. While the coupon accrual in the portfolio was very much there, down-tick in prices was taking away from the accrual. To recall the background why yields were moving up, it started from yields dropping significantly when the Reserve Bank of India (RBI) cut interest rates till 2020 to support the economy. From the very low levels, interest rates had to eventually move up. RBI’s rate hike cycle started in May 2022. However, interest rates in the market started moving up from 2020-end. This was due to multiple reasons: high inflation, high fiscal deficit leading to borrowings from the market, and anticipation of rate hikes by RBI.
As an indication, the 10-year benchmark government bond yield was at a low of 5.82 per cent in December 2020, and it started inching up from that level since then. Even before the RBI rate hike cycle started in May 2022, it crossed 7 per cent in anticipation of rate hikes.
In 2023, the biggest event for debt funds, as per the perception of investors, was the change in taxation. From April 1, 2023 onwards, indexation benefit is not available in fresh investments in debt funds. Over an investment horizon of three years, in the growth option of debt funds invested till March 31, 2023, indexation benefit significantly reduced the tax incidence. However, the impact was more psychological than real. From the taxation perspective, debt mutual funds are now more-or-less on a par with other fixed income investment avenues. The interest on bank term deposits is also taxable at the marginal slab rate.
Debt mutual funds are also taxable at the marginal slab rate, with a small additional benefit: it is possible to set-off against short-term capital loss, if you have any, in the growth option of the fund.
Direct bond coupons are taxable at the marginal slab rate; capital gains, if any, are taxable at a relatively lower rate. Taxation of portfolio management services (PMS) is a pass-through, as if you are holding the securities directly and not through any investment vehicle.
In terms of performance, 2023 was a stable year. The last rate hike by RBI was on February 8, 2023. After that, RBI paused interest rate hikes in five consecutive review meetings. Yield levels also moved in a range. It was more of accrual-based returns from debt funds, with a little bit here and there on market movement. As an indication, the 10-year government bond yield was approximately 7.15 per cent in January 2023, and it ended the year at a similar level. A point to note is that the 10-year bond is only one of the many securities in the market of multiple government bonds of various maturities and it is also referred to in the absence of a commonly tracked index, such as the Nifty or Sensex for equity markets.
There are expectations of interest rate cuts in 2024. Rate cuts are expected to start globally, in the US Federal Reserve and in Europe by the European Central Bank, sometime between March and May 2024. Policy rate easing cycle by RBI is also expected in in the second half of 2024.
But there is a nuance here: RBI’s approach to interest rates is “withdrawal of accommodation”. That has to be changed to neutral, and then subsequently rate easing can commence.
Hence the RBI’s rate easing cycle is expected after the initiation of the US and Euro-zone cycle reversal. As and when rate cuts happen in India, or the market starts building in expectation, yield levels would ease. Higher bond prices would also add to accruals in the portfolio in terms of favourable market movement. Another thing to note is that subsequent to yield levels coming down, accrual level would be that much lower subsequently.
As and when the rate cycle happens in India, it is expected to be a shallow one, 50 to 75 basis points (0.50 to 0.75 per cent). The rationale is that RBI’s monetary policy committee (MPC) would like to maintain a real positive repo rate over and above Consumer Price Index (CPI) inflation. The extent of this differential is a matter of interpretation and debate, as there is no set rule. Hence it primarily depends on the inflation trajectory and RBI’s forward projection of inflation. As per the latest available data, inflation is 5.69 per cent in December 2023, and with the repo rate at 6.5 per cent, the spread is approximately 80 basis points (0.8 per cent). If the repo rate is reduced by 50 to 75 basis points, and it becomes 5.75/6.0 per cent, CPI inflation has to remain comfortably within 5 per cent.
There is always a case for requisite allocation in the portfolio. Allocation to equity, debt and any other asset class as per your requirements. This is with or without tax benefits, such as withdrawal of indexation benefit from debt funds.
For a perspective, assets under management (AUM) of debt funds—in the usual categories apart from fixed maturity plans (FMPs) and target maturity funds (TMFs)—were Rs 12.3 lakh crore as on February 28, 2023. As an average for the month of February 2023, the AUM was Rs 13.03 lakh crore.
The rationale for referring to the AUM of February 2023, is that the changes in debt funds taxation was announced in the fourth week of March 2023. The amount of money managed in February 2023 was not diluted or impacted by any tax change, and hence it provides a fair base for comparison.
As on November 30, 2023, the AUM in the usual debt funds were Rs 13.58 lakh crore. As an average for the month of November 2023, AUM was Rs 14.1 lakh crore. The increase in money being managed in debt funds shows that tax efficiency is not the only criterion for allocation.
If you wonder which debt fund category is appropriate for you, it is largely a function of your investment horizon. You may ensure that the average maturity of the fund more or less matches your investment tenure. To catch the current yield levels, prior to any RBI rate cut, target maturity funds are advisable.
By Joydeep Sen, Corporate Trainer and Author