- Date : 10/04/2023
- Read: 4 mins
A look at debt fund viability as RBI pauses repo rate hike
The RBI repo rate has been on an upward trajectory for some time now. However, the latest monetary policy committee meeting of the RBI decided to maintain the repo rate at the existing rate of 6.5%.
Debt mutual funds have fallen out of favour for many investors after they lost the tax advantage from this financial year. However, with the recent MPC decision on repo rate, investors are looking at debt mutual funds as a potentially profitable investment.
Also Read: Debt fund taxation rule changes. What expert wealth managers say
Interest Rate and Debt Mutual Funds
Traditionally, an increase in interest rate has not been a good indication for debt mutual funds. RBI interest rate and bond prices have an inverse relationship. With an increase in the RBI interest rate, the bond prices fall. An increase in interest rate increases the coupon rate of new bonds, which lowers the demand for the older bonds. This, in turn, results in a lower yield in debt mutual funds. This is commonly known as duration or interest risk.
Presently, the interest rate on fixed-income investments, which dictates the debt fund yield, is in a lucrative position. If the inflation rate indeed dips as predicted, the real return from these investments would rise further.
Also Read: Find out SEBI’s new deadline for furnishing mutual fund nomination details
Future Interest Rate Trajectory
However, the stance of the RBI on interest rates is not clear yet. The repo rate had a two-year hold at 4%, before rising in each of the previous six MPC meetings. In a scenario with a sustained pause or lowering of interest rates, debt mutual funds perform well. But for RBI, the pause in repo rate may be a one-off decision before it decides to increase it further in the next meeting.
The RBI governor has clarified that until the inflation rate sees a sustained decline, RBI will continue to take the steps necessary to control inflation. An increase in interest rate is, of course, one of the obvious steps taken to fight inflation. Inflation was at a satisfactory 5.7% in December 2022 but rose to 6.4% in February 2023. The RBI has paused the interest rate for now with, perhaps, one eye on its FY 2023-24 projection of 5.2% consumer price index-based inflation.
Also Read: Can Makeover of debt mutual funds be better than FDs in India
Investing in Debt Funds and Fixed-Income Investments
While the rising trend in interest rates has been put on hold, rates are not expected to fall immediately as the economy is still going through uncertainties. In the meantime, any increases in bond yields can be good investment opportunities. Fixed deposit rates remain elevated for now, which is another investment option for the medium to long term. Investments in debt mutual funds, on the other hand, could turn profitable if the bond yields fall in the coming days.
With falls in interest rates not yet being a certainty, inflation can reduce the real return of fixed-income investments. This can impact the yields of long-term fixed-income and debt fund investments. Short and medium-term debt funds are comparatively safe from such interest rate and inflation uncertainties.
Conclusion
The pause in the RBI repo rate and positive expectations from the inflation rate are tempting indicators for debt fund investors. However, the underlying uncertainty means that it may be too early for long-term debt fund investment. A staggered approach towards it, on the other hand, combined with short and medium-term investments, can be a more safe addition to one’s portfolio.
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The RBI repo rate has been on an upward trajectory for some time now. However, the latest monetary policy committee meeting of the RBI decided to maintain the repo rate at the existing rate of 6.5%.
Debt mutual funds have fallen out of favour for many investors after they lost the tax advantage from this financial year. However, with the recent MPC decision on repo rate, investors are looking at debt mutual funds as a potentially profitable investment.
Also Read: Debt fund taxation rule changes. What expert wealth managers say
Interest Rate and Debt Mutual Funds
Traditionally, an increase in interest rate has not been a good indication for debt mutual funds. RBI interest rate and bond prices have an inverse relationship. With an increase in the RBI interest rate, the bond prices fall. An increase in interest rate increases the coupon rate of new bonds, which lowers the demand for the older bonds. This, in turn, results in a lower yield in debt mutual funds. This is commonly known as duration or interest risk.
Presently, the interest rate on fixed-income investments, which dictates the debt fund yield, is in a lucrative position. If the inflation rate indeed dips as predicted, the real return from these investments would rise further.
Also Read: Find out SEBI’s new deadline for furnishing mutual fund nomination details
Future Interest Rate Trajectory
However, the stance of the RBI on interest rates is not clear yet. The repo rate had a two-year hold at 4%, before rising in each of the previous six MPC meetings. In a scenario with a sustained pause or lowering of interest rates, debt mutual funds perform well. But for RBI, the pause in repo rate may be a one-off decision before it decides to increase it further in the next meeting.
The RBI governor has clarified that until the inflation rate sees a sustained decline, RBI will continue to take the steps necessary to control inflation. An increase in interest rate is, of course, one of the obvious steps taken to fight inflation. Inflation was at a satisfactory 5.7% in December 2022 but rose to 6.4% in February 2023. The RBI has paused the interest rate for now with, perhaps, one eye on its FY 2023-24 projection of 5.2% consumer price index-based inflation.
Also Read: Can Makeover of debt mutual funds be better than FDs in India
Investing in Debt Funds and Fixed-Income Investments
While the rising trend in interest rates has been put on hold, rates are not expected to fall immediately as the economy is still going through uncertainties. In the meantime, any increases in bond yields can be good investment opportunities. Fixed deposit rates remain elevated for now, which is another investment option for the medium to long term. Investments in debt mutual funds, on the other hand, could turn profitable if the bond yields fall in the coming days.
With falls in interest rates not yet being a certainty, inflation can reduce the real return of fixed-income investments. This can impact the yields of long-term fixed-income and debt fund investments. Short and medium-term debt funds are comparatively safe from such interest rate and inflation uncertainties.
Conclusion
The pause in the RBI repo rate and positive expectations from the inflation rate are tempting indicators for debt fund investors. However, the underlying uncertainty means that it may be too early for long-term debt fund investment. A staggered approach towards it, on the other hand, combined with short and medium-term investments, can be a more safe addition to one’s portfolio.
Source:
