After demonetisation, many fixed-income fund managers were of the opinion that the Reserve Bank of India (RBI) would cut the repo rate by another 50 basis points (bps) by the first quarter of the next financial year. Consequently, many financial advisors had turned bullish and were advising their clients to increase exposure to longer-duration debt funds to benefit from the expected decline in interest rates. But with the RBI choosing to pause, leading to a sharp spike in bond by 20 basis points, retail investors need to re-evaluate their debt fund strategy.
Experts say that the RBI chose to hold the repo rate due to its discomfort with inflation. "While headline inflation has come down, core inflation remains at an elevated level. The central bank also fears that once the base effect wears off, inflation could start inching up again," says Akhil Mittal, senior fund manager, Tata Mutual Fund.
Developments in the global financial markets and their impact on the Indian currency also led to the RBI turning cautious. Indian bond yields are falling while those in the US are rising due to which the difference between the US and Indian 10-year treasury bond yields is narrowing. "There is now a negative carry net of hedging costs, which has led to foreign institutional investors (FIIs) selling $8.11 billion in the Indian markets since demonetisation. Of this $5.36 billion was in the debt market," says Kunal Bajaj, founder and chief executive officer, Clearfunds, a Sebi (Securities and Exchange Board of India) registered online mutual fund advisor. (Carry trade refers to the practice of FIIs borrowing in low-interest rate markets and investing in those with higher rates). He adds that if local rates are cut further, it would create the risk of bigger outflows. The US Fed could hike rate at its next meeting in mid-December, so the RBI probably wants to wait until that event. It would also want to look at the whether the Indian government offers a fiscal stimulus in the Budget.
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Most market experts now expect at best a 25-basis-point rate cut in February or April. But they also believe that uncertainty around this event has increased. With the end of the rate easing cycle near, yields are expected to either remain at the same levels or move up. The hefty capital gains that investors were anticipating from longer-duration funds may not materialise.After the Organisation of the Petroleum Exporting Countries (OPEC) agreed to supply cuts, crude oil prices have started moving up. If they rise further, they could hurt India, a big importer of crude. Analysts expected the central bank to cut rates in the December 7 policy meet to counter the slowdown in GDP (gross domestic product) growth expected due to demonetisation. However, the RBI doesn't think the impact will be so big as to warrant action now. "RBI has clearly specified it needs more data and time to evaluate the effects of demonetisation and clearly does not want to react disproportionately to 'short-term transient' effects," says Bekxy Kuriakose, head-fixed income, Principal Pnb Asset Management.
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Conservative investors should stick to shorter-duration funds. Says Bajaj: "RBI has made it clear that it will keep liquidity in surplus or neutral, so short-term rates may not spike."
According to Mittal, "Only investors with the requisite risk appetite should enter longer-duration funds, after evaluating the outcome of the Fed policy meet." For aggressive investors looking to profit from volatility in longer-term rates, Bajaj suggests investing in dynamic bond funds, but only those that don't aggressively move the duration of their holdings.