The recently concluded RBI monetary policy has been the talk of the town with the central bank changing its stance to accommodative from neutral. RBI came up with a 25 bps cut in the repo rate – a third cut during the year. The action validates the fact that the domestic and global economic conditions warranted rate reduction.

In this blog, we seek to discuss how the RBI rate cut will impact different asset classes, particularly debt funds.

Background

The increase in the output gap and a slowdown in key sectors along with recent data depicting the economic health compelled the central bank to believe that a monetary push is again required to bring the economy on the path of growth.

But what was surprising is the fact that RBI changed its stance from neutral to accommodative. For novice readers, changing the stance means that the ecosystem of low-interest rate is likely to remain, and there is no possibility of a rate hike shortly.

Also, it means that if there is a need, RBI is flexible to reduce the interest rate further to support economic growth.

Impact of Rate Cut on Debt Funds

What is EPF Balance?

We believe a low-interest rate environment will affect different debt funds. However, the impact is dependent on the portfolio composition, particularly duration and accruals.

Before delving directly to assess the impact of a rate cut on debt funds, it is essential to understand that not all debt funds will react similarly to rate cut.

Let’s see how the impact will be structured.

1. Funds Earning Through Coupon

Funds that earn its primary return from the coupon payment on the fixed income instrument could see a reduction in the interest income due to the declining interest rate.

Thus, the yields would be declining due to falling interest rates.

The funds that belong to such categories are the ones with a very low duration such as overnight funds or liquid funds. The instruments in these funds mature rapidly due to low tenure.

Thus, the money has to be reinvested in instruments bearing low-interest income, thereby leading to a reduction in returns.

2. Funds Earning Through Both Interest and Appreciation

Some funds seek to make returns through both, appreciations in the value of the instrument, along with coupon interest.

In the event, the interest rate in the economy goes down, the value of bonds with higher coupon naturally go up. Thus, the returns contributed from the appreciation of bond price increases. Therefore, the longer is the tenor of the bonds; more significant will be the impact of a change in interest rates on its value.

The fund that belongs to such category is gilt funds, long-term debt funds, medium-term debt funds, etc. These funds see a more significant cut in their NAV when the interest rate goes up.

What Should an Investor Do?

People often think that an investor should shift to funds that are likely to benefit more. However, the answer depends on what an investor is looking for.

1. If Debt Funds are a Part of Your Core Portfolio

If debt funds are a part of the core portfolio of an investor, the investor should look for short duration funds, corporate bond funds, PSU bond funds, and the likes. These funds have high creditworthiness and come with average maturity duration of 1-3 years.

We believe this portfolio is likely to see some benefit due to a reduction in interest rate. These portfolios are also expected to see lower volatility in returns in the event of fluctuating interest rate too.

A short-term debt fund or a corporate bond fund with an average duration of 2-3 years is likely to see a benefit of 1% in returns when the interest rate moves south by a similar quantum.

Also, the spread in the corporate bond is attractive at around 80 bps in both the ten-year structure and 3-5 years bucket.

After the recent fiasco of Dewan Housing Finance Corporation Ltd (DHFL), the investors will continue to chase the AAA bonds and the spreads for AA will shoot up further.

2. Debt Funds are a Part of Your Tactical Strategy

If the investor is looking to take benefit of the expected fall in yield and the subsequent appreciation in the price of the bond, then an investor may look at the long-term duration funds such as gilt funds, long-term funds, etc.

The returns from these funds are likely to be volatile as the bond prices will react more to changing the interest rate. The gilt funds and long-term debt funds are generally used for tactical plays were opportunities during the times like 2013 and provides an opportunity for capital gain.

3. If Credit Risk Funds Remain Favorable for Tactical Strategy

You can search for opportunities in well-managed credit risk and dynamic funds for tactical gains.

These funds are suitable for investors who are willing to stay with the volatility for some period. These funds align to benefit from duration when rates are expected to decline or from the actual strategy under the interest rates go up.

This strategy allows an investor to not chase the market. The only risk remains is that the fund managers may miss the cues on yield, thereby resulting in underperformance.

Conclusion

To conclude, we believe the rate cut during the monetary policy was business as usual and an expected move.

What was important was the change in stance and the focus on liquidity, implying a possibility of lowering rate in near to medium term.

From an investor’s viewpoint, focus on stability for the long-term along with tactical calls for short-duration from satellite portfolio. This should help you remain abreast of the market at all times and get optimal benefit.

Happy Investing!

Disclaimer: The views expressed in this post are that of the author and not those of Groww