What Should Debt Fund Investors Do?

The past 2 years have been a roller coaster ride for debt fund investors! First, they witnessed the incredible drama of the sudden shut down of 6 debt funds of a leading AMC. Post that, bond markets staged a recovery of sorts, allowing the shut funds to pay back moneys to investors slowly but steadily. The RBI’s accommodative stance cushioned the blow by ensuring ample liquidity, but bond markets remained volatile in light of vastly increased government borrowings. The Union Budget drove yields upwards, and they have remained high since – with the 10-year hovering around the 6.9% mark; up significantly from the 6.3% levels it was trading at in December ‘21. In this volatile environment, even bellwether debt funds have struggled to return anything upwards of 5-6% returns to investors on an annualized basis since 2020 despite the RBI’s efforts at stabilizing markets with large bond purchases.

Although the RBI has kept its stance as accommodative, markets have been reacting to the hawkish tone of the Fed, that has been steadily signalling future rate hikes amidst inflationary concerns. 

To make matters worse, we now have an evolving geopolitical situation that has sent crude prices into orbit – they shot past the $133/bbl mark today. To put it mildly, the impact of such a massive rise on the domestic economy is severe, as India imports 85% of it’s oil. This will hurt our current account deficit, our fiscal deficit – and most importantly, stoke inflation to the point that the RBI can no longer remain accommodative. It’s a matter of time now before we start seeing what could be a series of rate hikes over the coming months – and that’s never good news for debt funds.

Given the challenging macro situation, it’s unlikely that the pressure on yields will ease off anytime soon despite valuations looking attractive for long term bonds (the gap between the repo rate and current yields are 2.9%, which is much higher than historical averages). A couple of future rate hikes may well be prices into current yields, but the current dynamic situation doesn’t warrant heroics on the debt side. 

Investors will be better off sticking to medium duration bond funds that have an average maturity of 3-5 years with the bulk of their investments, and also ensure that they invest into funds that have creditworthy portfolios. It would make sense to divert some of your debt fund money to arbitrage funds as well, as volatile equity markets generally bode well for them. At the very least, they will most likely outperform liquid or ultra-short-term funds on a post-tax basis. The call on whether to lock in yields at these levels should be taken only after more clarity emerges on the evolving geopolitical situation over the next few months.