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Some debt fund categories gain as rates decline, but FDs lose out

The Reserve Bank of India’s (RBI) monetary policy committee met for the last time in calendar year 2019 and in a surprise move paused the rate cut cycle keeping the repo rate at 5.15%. However, it maintained the stance as accommodative, signalling that the rate cut cycle is not over. RBI governor Shaktikanta Das emphasized the importance of the transmission of past cuts to the lending rates soon to help revive the flagging economy.

A flip side to the lending rates coming down is that the deposit rates offered by lenders such as banks also comes down. “The transmission to deposit rates has been only around 10 basis points (bps) against the 135 bps cut in repo rates in this year. The deposit rates need to go down further for the transmission of rate cuts to happen effectively,” said Ajay Manglunia, managing director and head, institutional fixed income, JM Financial Products Ltd. Investors who look to earn a return from products like deposits will find their interest income declining. The interest offered on small savings schemes have also marginally declined, but not as much as they should, given that the rates are now reset quarterly with reference to the rates on government securities (G-secs) of comparable maturities. The transmission of the rate cuts has been 89-113 bps in the G-sec market in this rate cut cycle, but the government has chosen to keep the rates artificially high for now on these investment products. But this may not continue and investors may soon see the rates on these products too reflecting the lower interest rate environment.

When lower interest rates are accompanied by higher inflation, then investors see their real returns decreasing. How do investors protect the returns from their fixed-income portfolio in a declining interest rate environment? It takes a mindset shift to do this. Investors should give up looking for fixed returns from their investments. The cost of the assurance is lower returns. On the other hand, open-ended debt funds earn a return that is a combination of coupon income and gains in the value of securities that reflects current market rates. When interest rates in the markets decline, the value of the existing bonds in the portfolio goes up and this adds to the total return from the fund. However, when interest rates rise there is a decline in the value of securities and this may eat into the coupon earned and reduce the total return from the fund.

The extent of gain or loss in the value of securities is a function of the tenor of the bonds— higher the tenor, greater is the impact on the value of the bond. The way to deal with this volatility is to invest in a portfolio with a duration not greater than the investment horizon of the investor. For example, overnight and liquid fund categories are suitable for very low investment periods and they hold securities that have very low tenors too. The primary return is from coupon income and that explains the reduction in the return from these funds in the current low interest environment.

Source: Valuereseachonline.com, Mint research

“The corporate bond rates in the money markets have already gone down as much as 150-200 bps, as a result of the rate cuts combined with the credit issues in the market,” said Manglunia. As such, the return from the funds in the shorter horizons is unlikely to improve from these levels.

On the other end of the spectrum, funds such as short duration and medium duration have seen their returns go up significantly in a falling interest rate scenario from the gain in the value of securities held in the portfolio. “The one-to-three-year segment looks the most attractive at this stage for investors to consider. There is scope for better risk-adjusted returns in this segment. The long duration space will need more clarity on fiscal discipline and inflation which is not there at this point,” he added.

For the best fit, don’t let the returns guide the selection of a fund, but consider the tenor of the portfolio relative to your investment horizon, the credit quality and features such as concentration. For the core portfolio, you should consider funds that keep interest rate risk and credit risk low.

Selecting a suitable debt fund may not be as easy as selecting a fixed deposit, but the effort to select the right schemSe will mean that your portfolio is protected from the risks of low returns in a period of falling interest rates.

Source: livemint