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Debt Fund Returns Fall After RBI Leaves Rates Unchanged

If you’re a new investor just looking to deploy money, it would be prudent to opt for predominantly accrual based funds with moderately rated portfolios and sub-1 year modified duration

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In its 6th bi-monthly MPC meeting on Wednesday, the RBI sprung a surprise by leaving key rates unchanged. The Repo rate stayed at 6.25 per cent, whereas the reverse Repo and MSF rates remained the same at 5.75 per cent and 6.25 per cent, respectively. Debt Fund NAV’s took a nosedive after the announcement.

Inflationary worries and global uncertainties were, per RBI Governor Urijit Patel, the key reasons behind this decision. Demonetization led woes, he said, are ‘transitory’ in nature. The RBI also slashed the GVA growth rate from 7.1 per cent to 6.9 per cent, predicting a recovery to 7.4 per cent by FY18.

Bond Yields reacted sharply to the news. The 10-year G-Sec yield spiked by a massive 32 bps on 8th February, and bond prices fell across the board. For those not aware – bond yield rise when bond prices fall, thereby increasing the ‘yield’, or the annualized return one can earn by buying the bond at the depressed price and holding it until its maturity. However, this is bad news for those already invested into debt instruments, as they need to contend with mark to market losses arising from the fall in bond prices. Prior to the announcement, the 10-year G-Sec yield stood at 6.43 per cent – post the announcement, at a much higher 6.75 per cent.

This is the second shock for debt investors in the last quarter. Previously, they had faced consternation when yields plummeted to 6.2 per cent post demonetisation, only to spike back sharply to 6.4 per cent or thereabouts.

Longer term debt funds- or funds that on average, hold paper with later maturity dates, are impacted the most due to changes in yields. To predict the impact of yield changes on short term returns for a particular fund, the ‘modified duration’ parameter comes in handy. For instance, if a fund has a modified duration of 5 years and yields rise by 32 bps or 0.32 per cent, the net impact on the NAV can be expected to be to the tune of 5 times 0.32 per cent, or -1.6 per cent. The reverse holds true in case of falling yields; a good sign for debt investors.

To illustrate this effect further, consider three debt funds of varying modified durations.

Franklin India Low Duration Fund, with a modified duration of just 0.96 years, hardly took a hit at all. It’s 1-week return stands stoically at -0.05 per cent.

ICICI Prudential Long Term Fund, with a modified duration of 5.28 years, fared worse. The detrimental impact of the 32 bps rise in yield on its NAV would have been to the tune of 1.68 per cent (5.28 times 0.32 per cent). The fund’s 1-week return stands at -2.18 per cent.

Birla Sun Life Dynamic Bond fund, evidently betting on a rate cut, was maintaining a portfolio modified duration of 8.14 years. Understandably, it’s NAV fell after the announcement. The fund’s 1-week return stands -3.04 per cent.

The sizeable fall in debt fund NAV’s have surprised many investors, several of whom are really unaware of the nuances of debt fund investing; harboring the mistaken belief that bond funds are like fixed deposits, providing an assured rate of return. However, there are no free lunches in the investment world!

What should debt fund investors do now, particularly those who invested immediately prior to the announcement and are sitting on losses? The answer is, do nothing. We’re not really in a bad place, rate cycle wise. Hawkish comments notwithstanding, it’s likely that inflation will ease off and make room for at least one rate cut of 25-50 bps this year. That will more than help you cover up for this interim drop. It’s unlikely that yields will rise significantly from the current levels, either, so accruals should start kicking in for the next few months.

If you’re a new investor just looking to deploy money, it would be prudent from a risk-reward standpoint, to opt for predominantly accrual based funds with moderately rated portfolios and sub-1 year modified durations. Franklin India Low Duration Fund and Reliance Medium Term Fund are good bets. For those that can stomach slightly higher volatility and have a time horizon of at least a year, DSP BlackRock Income Opportunities Fund is a worthy option to consider.

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