Credit Policy Impact: Debt Funds See One Week Losses As Yields Surge

Debt fund returns turned negative over the past week as yields spiked sending bond prices tumbling. The 10-year G-sec yield surged to 6.78 per cent (from 6.4 per cent) after the RBI left interest rates intact, which was unexpected. Debt funds, as a result, saw some losses in the past week before February 8, 2017.

One week returns of medium-to-long term gilt funds lost the most dropping -1.77 per cent, while dynamic bond funds lost -1.24 per cent. Income and short term gilt funds also dipped -0.93 and -0.48 per cent respectively as per Valueresearchonline.com. Longer duration debt funds lost more on average against short-maturity funds.

By contrast, investors reaped a decen one-year returns in medium-to-long duration funds of over 15.7 per cent. But now with the Monetary Policy Committee changing its stance from ‘accomodative’ to ‘neutral,’ it may have negative implications for the rate cycle and debt fund investors.

The RBI has been on a rate cutting spree since January 2015. The RBI also kept the policy repo rate unchanged at 6.25 per cent in its credit policy. A ‘neutral’ stance means that the RBI could increase or decrease rates in the future or even leave it unchanged. An ‘accomodative’ stance meant that RBI may be obliging on the downside, which is generally more beneficial for the bond market, particularly long term bond funds.

Rising interest rates hurts bond fund returns as debt paper see a rise in their prices as they adjust the changes in market yields. Currently, the 10-year benchmark g-sec is currently hovering around the 6.78 per cent mark. Yields on government paper had dipped after November 8 from the pre-demonitisation levels of around 6.9 per cent. R Sivakumar, Head of Fixed Income, Axis Mutual Fund tweeted that the yields spiked +32 bps on the day, and they are back to pre-demonitisation levels.”

Now with the RBI changing its stance to neutral, the interest rate cut cycle may have come to an end in the short run. Experts point out that this stance may have been taken because the US Fed has indicated that there are three more rate increases in the offing. Hence, this scenario does not provide much head room to cut rates.

Rising rates impact bond funds negatively. Medium-to-long term gilt funds are the most impacted as they hold higher average maturities as compared to short-duration funds. In the coming months, if bond yields show a rising tendency, long-term debt funds may get further impacted.

As yields may continue to exhibit volatility in the coming months, debt fund managers have begun recommending an accrual strategy. That means investors should not invest in debt funds for bond gains, but rather to accumulate the interest earned on these funds over the course of its maturity.

Says Lakshmi Iyer, chief investment officer (Debt) & Head of Products, Kotak Mutual Fund: “We view the policy as unexpectedly hawkish and the markets’ unpreparedness has led to spike in yields. It may be prudent, therefore, to continue to focus on accrual strategies predominantly as guided earlier, with a top of duration especially given the sharp spike in yields.”

In short, stay invested in debt funds over the course of its maturity and let the interest accrue in the NAVs.