RBI Policy: Key Takeaways For Debt Fund Investors

The Reserve Bank of India kept key policy rates unchanged in its bi-monthly policy review meet yesterday. The repo rate has been maintained at 6%, and the reverse repo rate at 5.75%.

In recent times, there's been a steady rise in the popularity of debt mutual funds. With FD's and other traditional fixed income instruments barely outpacing inflation, retail investors have flocked to debt mutual funds in hordes. The fact that net inflows into debt funds grew seven-fold from 30,000 Crores to 2.16 Lakh Crores, underscores this.

One of the key influencers of debt fund returns is the stance that the Reserve Bank of India adopts with respect to underlying interest rates in the economy. Falling interest rates result in an increase in bond prices, and vice versa. The quantum of price movement is contingent upon the duration of the bonds in question, with longer maturity bonds displaying higher interest rate sensitivity than lower maturity bonds. Therefore, debt funds such as long-term GILT funds that invest into long maturity papers, tend to be more volatile that lower duration "accrual based" funds.

The bond markets had already been pricing in this move of keeping rates constant, and so this came as no surprise. In fact, the yield on the 10-year G Sec had risen by roughly 20 basis points or 0.2% in the month leading up to the policy meet. Consider the impact of this rise in yield on two funds - SBI Magnum Long Term GILT (a long-term debt fund) and Franklin India Low Duration Fund (a short term, accrual based fund). The former's NAV has fallen by 0.58% in the past month, while the latter has risen by 0.48% in the same period.

Given that inflation has been steadily under control for the past year (beating the RBI's target of 4%), and the fact that GDP growth has been muted to say the least, some may have expected the RBI to adopt a more aggressive stance with respect to rate cuts.

The RBI's policy wordings suggest that it isn't yet fully confident about inflation figures, citing that the recent fall can be attributed more to transitory factors such as an unexpected fall in food prices. It expects inflation to rise back to 4.6% by the end of the Financial Year.

The governor also expressed his concerns over the risks of fiscal slippage that would result from the UDAY scheme and the various farm loan waivers that have been announced in recent times, all of which increase the risk of inflation within the economy.

Given the 'neutral' stance adopted by the RBI in yesterday's meet, it seems highly likely that rate cuts could go on a long pause for a couple of quarters at least.

In such a scenario, debt fund investors should ideally stick with shorter term, accrual based funds, and avoid longer term GILT funds. Annualized returns of 8% to 8.5%, with moderate risk, is achievable from short to medium term debt funds that invest into moderate to high credit rating portfolios. If you're already invested into GILT funds, you could consider switching into a mix of short term, ultra-short term, and dynamic bond funds. An average portfolio modified duration of 2-4 years can be aimed for.