Returns on traditional fixed income investments are down with SBI fixed deposit offering a maximum of 5.4% per annum. Even liquid fund returns and ultra short term funds are offering 3-4% returns. Given this, what is the option for an investor in debt mutual funds?
Historically bank deposits over the medium term have underperformed debt mutual funds in terms of returns. For an investor with a 2-3 year horizon, banking and PSU debt funds are a good option. The portfolio of these funds have high quality banking and PSU names. Since interest rates are cyclical in nature, if government borrowings and inflation is high, rates will go up for a while giving an opportunity to fund managers to add more paper at higher yields. Overall once interest rates settle, investors will get good returns. Time and again we have seen high interest rates do not last forever and hence pulling out money has not helped investors as it is difficult to time the market.
What is the biggest advantage of debt funds?
Debt MFs have historically given higher returns than other options. You can redeem any time, even if there is a small exit load. The biggest advantage is that here the returns are market linked, when rates go down he gets maximum participation. This is the biggest factor in favour, However investors need to be careful of credit risk as that could be a permanent damage.
Where are interest rates headed after the series of rate cuts we saw earlier?
This is a dynamic market depending on how the economic environment evolves, as of today we are in a drastically contracted growth scenario and there is intent of the government to revive the economy and the reserve bank intent to support it in whatever way possible. Given that interest rate is one factor which has to be on the lower side to support recovery of the economy, at this point when inflation has gone up, it poses a challenge as to how long can one keep interest rates low.
Interest rates will likely remain range-bound in the near term. One can say with some confidence interest rates have practically bottomed out. It will need good effort from RBI to keep interest rates at lower end, between the pull and push of poor economic situations and rising inflation and fiscal deficit. Any upside pressure will be smoothened by RBI by intervention by open market operations whereas the market does not have support of fundamentals to take rates down. This tug of war will continue for some time and eventually I think interest rates have to move higher is my view at this point of time. Prospects of rates coming down significantly from here are low.
One reason why investors are averse to investing in debt funds is that return is not guaranteed, while other debt instruments guarantee return. Many investors try to arrive at returns in a fund by taking the yield to maturity (YTM) minus expense ratio?
I do not think this is the best way to look at returns from a debt fund. This is because if interest rates go down, there will be capital gains and vice versa. Investors need to understand what stage of economic or interest rate cycle they are entering, and what strategy the fund manager is following. It is unlikely a small investor will understand these nuances, so simply put, if you are investing in a bond fund, there is higher volatility due to the high impact of interest rate movement and in a liquid fund volatility is less. So it boils down to the fact that if you have short term money for 4-6 months put it in a liquid fund and don’t get into a bond fund as volatility will be there and it will not match your investment horizon. Those with long-term horizon and patience with volatility may consider bond funds.
Investors should also look at the track record of the fund and make an estimate based on that. Interest rates are like commodities where there is cyclicality. You need to be ready to remain invested in one full investment cycle. Invest in a good quality product with a good strategy and avoid credit risk.
There are fears that asset quality of banks will decline due to the pandemic and the moratorium. What could this mean for the bond markets?
This is called recency bias, a well-known cognitive bias that favours recent events over historic ones. We know about pandemic and hence we are talking about this. Don’t get too influenced by recency bias. Risk of credit default was highest even before the pandemic broke off. Avoid taking aggressive credit risk and make sure your money comes on time. The common fundamental is that weaker companies will be affected by any adverse development first and there are sectors like infrastructure and real estate which are more affected by government policy, which investors should avoid.
Globally trillions of dollars are parked in negative yielding bonds. What does this mean for India?
It means that the global interest rate environment is supportive; it gives RBI much bigger elbow room to manage interest at lower levels. Suppose the interest rate environment is not benign RBI will find it difficult to keep interest rate in check. If you look at the last 25 years, every time there was a turbulence in local markets, it had its origin in the global markets. We are a country with a current account deficit so anything that brings turbulence and volatility in global markets, will affect capital flows to India and cause pain to domestic markets.
If global markets are flush with liquidity it brings more capital flows to India because we have a great potential. This helps keep currency stable and domestic liquidity easy and interest rate low. Low rates abroad also means that interest rates will not go up, because the global environment is supportive. Most global central banks have a strong commitment to keep interest rates low, and truth be told their ability to hike interest rate is next to nothing. Any spike in global yields will be short lived. That is one factor less to worry for the RBI.