Should Debt Fund Investors Worry About Possible Rate Hikes?

Debt Mutual Fund investors have had a harrowing time over the last 18 months, with many schemes delivering flat to negative returns in the last year. Anecdotal evidence suggests that a lot of first-time investors joined the fold during this period, fed up as they were by the low fixed deposit rates that banks had on offer. Little did they know that they were going from frying pan to fire!

A confluence of factors has led to steadily rising bond yields over the past year and a half - the foremost being crude prices, which have "barreled" towards the $80/bbl mark with a degree of ferocity that very few professional analysts could have predicted. In hindsight, several analyses justifying this steep rise have materialized - increased supply, the Iran sanctions, the situation in Venezuela, and the impending Saudi-Aramco IPO, to name a few. 

When crude prices rise, it throws Indian macros into a tizzy - as the fiscal deficit widens and inflation creeps up. When inflation rises, the RBI jumps into the rescue of the 'aam aadmi', raising interest rates and stifling the supply of money. And when RBI raises interest rates, bond prices fall.

To make matters worse, global majors now predict that rate hikes are in the offing. According to financial services powerhouse Morgan Stanley, the Reserve Bank is expected to begin its rate hike cycle from December quarter and may go for three rate hikes by 2019 taking the key policy rate to 6.75 per cent.

As a debt fund investor, should you worry? Well, the short answer is - no.

There are a few things you need to consider here. Firstly, as is the case with all securities markets, bond prices rise and fall in anticipation of rate hikes - not necessarily after a rate hike happens. Given that the 10-year G Sec yield is hovering around 7.8% nowadays, we are now witnessing a massive 180 basis point spread between the repo and the 10-year yield. Traditionally, this gap has seldom exceeded 0.50% to 0.75%. And this begs the question - are two or three rate hikes already being prices into current yields? Quite likely, yes.

Two, the crude rally will not last forever. It's a matter of time before higher inventory flows put a stop to the tearaway rally, and crude prices settle down or even begin to correct.

Three, there's a veritable smorgasbord of debt funds to choose from. The ones that are sensitive to changes in yields are those that invest into higher maturity papers. If you're worried that yields will go soaring past the 8% mark, stick to low duration funds and breathe easy. Do not fall for the 'invest into dynamic bond funds and we'll take the duration calls for you' spiel that fund houses dole out - most of them have been extremely inept at predicting yield movements not just in the past year, but forever!

I dare say that the time to lock in duration, at least with part of your fixed-income money' is here. It's quite unlikely that yields will spike much beyond the 8% mark, and they may even trend down based on incoming data prints and news flows. A 70:30 split between low duration and high duration debt funds would be worth considering right now.