RBI repo rate cut and debt mutual fund downgrades: What should MF investors do now?

Stick with funds that have well-diversified portfolios tilted towards AAA or similarly rated securities.

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A falling interest rate scenario is rewarding for bond fund investors.
Even as bond funds reel under defaults and rating downgrades, the bond market is witnessing a significant change in trajectory. Last week, the central bank cut the repo rate by 25 basis points (bps)—the third straight cut takes the total to 75 bps this year. More significantly, the Reserve Bank of India (RBI) changed the monetary policy stance to ‘accommodative’ from ‘neutral’. Due to the rate cut and shift in stance, the bond market has rallied sharply. What does this mean for investors and how should they position their fixed income portfolios now?

Clarity on interest rates
The rate cut by the central bank was along expected lines, but the shift in policy stance is of greater significance. “Cutting repo rate below 6% and changing the stance to accommodative has happened only twice in the past 20 years,” says Arvind Chari, Head, Fixed Income & Alternatives, Quantum Advisors.


The RBI has also lowered the projected GDP growth for 2019-20 by 20 bps to 7%. This, along with the shift in stance, means that RBI is more concerned about the slowing economic growth than the inflation trajectory, and is more amenable to lowering rates further to aid growth. “The shift from neutral to accommodative removes ambiguity about the direction of rates,” says Lakshmi Iyer, CIO, Debt, and Head, Products, Kotak Mahindra Mutual Fund. Some global factors also bode well for the domestic bond market. The US Federal Reserve has adopted a dovish stance, which will ensure continued foreign investments in Indian bonds. Crude oil prices have crashed to below $60 per barrel, which will keep the current account deficit in check and inflation muted.
With these positives in place, analysts expect at least 50 bps additional cut over the course of this year. A falling interest rate scenario is rewarding for bond fund investors. When rates fall, bond prices rise. Debt funds have already benefited from the fall in rates in recent months. Long-term debt funds have clocked 13% return over the past year, while gilt funds generated 11.5%. With rates expected to come down further, these funds may continue to reward investors.
Portfolio risk: Going from bad to worse
Heavy redemptions are altering funds’ risk profi le by reducing their AUMs and leading to high concentration.

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The benchmark 10-year government bond yield has fallen from 7.37% at the start of the year to 6.9% now. Analysts expect yield to soften in the coming months. “We expect the yield to remain in the 6.75%-7% range with a downward bias,” says Avnish Jain, Head, Fixed Income, Canara Robeco Mutual Fund. “Bond yields may have room to drop further as the market expects more rate cuts. The 10-year government bond yield is still attractively valued as more rate cuts get priced in,” says Chari. But experts caution against too much exuberance. R. Sivakumar, Head, Fixed Income, Axis Mutual Fund, feels that the softening yields phase is mostly behind us. He suggests investors to maintain a core part of their portfolios in short-term debt funds with less than three-year duration.

The rot deepens
Even as the bond market makes merry, debt fund investors have to grapple with the elephant in the room. With credit defaults piling up, it is clear that the malaise in debt funds runs deep. Besides the IL&FS blowout, downgrades in DHFL, Essel, ADAG and YES Bank, among others, have hit debt funds hard. Any gain from rate cuts offer little respite to investors who have seen their funds’ NAVs erode sharply. The most recent downgrade in DHFL securities saw bond funds losing up to 53% of their NAV in a single day. Unless they are able to recover some money from DHFL in the coming days, it will take many years for these debt funds to regain their lost value.

Mayhem in bond funds
DHFL’s payment default wiped out several years’ worth of returns for many bond funds.
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The problem facing the investors now is that heavy redemptions are altering the risk profile of the fund. Fund managers have been forced to sell some of the more liquid, better quality instruments in the portfolio to cater to large-ticket redemptions. This has saddled the portfolios with low quality bonds. So, the impact of any more credit defaults on funds’ NAVs will be much more severe.

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While some fund houses will tide over the problems by merging affected schemes with larger funds, the entire episode presents a moment of truth for investors. It is time to get back to the drawing board and re-assess one’s debt fund portfolio. Avoid any bond fund whose portfolio now stands over-exposed to a single issuer owing to redemptions. Stick to funds with well-diversified portfolios, with a tilt towards AAA or similarly rated securities. “It is imperative that investors not only stick to high quality, but also stay away from concentrated portfolios,” says Sivakumar. Also, this cannot be a one-time exercise. Monitoring the portfolio quality and concentration should be made a regular exercise.
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