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With Rising Interest Rates, Here’s What You Should Do With Your Debt Fund Investments

The RBI has hiked the repo rate by 40 bps to 4.4 per cent and the cash reserve ratio by 50 bps in a surprise, unscheduled announcement. What should be your debt fund investment strategy?

With Rising Interest Rates, Here’s What You Should Do With Your Debt Fund Investments
With inflation so high, further rate rises are possible. Given the current environment, debt fund investors should favour short-term funds, particularly those with maturities of less than two years.

The Reserve Bank of India (RBI) surprised the market with an unscheduled announcement on monetary policy on May 4, 2022. 

With inflation on a high, further rate hikes are a possibility. So, given the current conditions, debt fund investors should opt for short duration funds, especially those with maturity not longer than two years. Here’s how, and why.  

The RBI Repo Rate Hike

The repo rate has been hiked by 40 basis points (bps) to 4.40 per cent with immediate effect. The RBI also decided to hike the cash reserve ratio (CRR) by 50 bps to 4.50 per cent. The CRR hike would be effective from the fortnight starting from May 21, 2022 and would withdraw about Rs 87,000 crore from the system. 

The hike in the repo rate was aimed at easing the high pressure of inflation, whereas the hike in CRR was to unwind the easy monetary policy, and drain the excess liquidity out of the system. The RBI Governor also raised a concern about food inflation. Notably, the March retail inflation touched 7 per cent, which is much higher than the RBI comfort level. 

Inflation Vs Growth

Till the last policy review, the RBI had chosen growth over inflation. But now, it has flipped the stance, as inflation is going beyond its comfort zone. 

Inflation
Until the most recent policy review, the RBI prioritised growth above inflation.

Experts are of the opinion that the RBI is sacrificing growth to contain inflation. “The governor clarifies that the hike in interest rates is to contain the second-round effect of supply side shocks. To our mind, it means that while supply side factors cannot be contained by monetary policy, the RBI seems to have decided to restrict future inflation by sacrificing demand” says Nikhil Gupta, chief economist, Motilal Oswal Financial Services.

Interestingly, the rate announcement came when all eyes were on the US rate setting panel of the US Federal Reserve. Within a gap of less than 12 hours, the US Fed also raised the rates by 50 bps, the highest in the last 22 years. 

Some experts see the decision to increase rates as a proactive move by the RBI. “Hiking before the Fed decision acts as a signal to the markets that the RBI is acting on its own and is not being forced by any actions of the Fed,” says Arvind Chari, chief investment officer, Quantum Advisors.

Short And Sweet 

RBI as well as global central bankers have embarked on a path to bring inflation down by raising rates and reducing liquidity. Wages are increasing and food prices are soaring as are commodity prices. Adding to the list of woes is the supply side constrain from China.

RBI
The RBI, as well as other global central bankers, have begun a policy of rising interest rates and restricting liquidity in order to reduce inflation.

Experts believe that it is time to opt for short duration. “The environment is adverse for investing in risky assets. The only safe investments are those below 2-year maturity as the risk reward appears to be turning favourable,” says Sandeep Bagla, CEO, Trust Mutual Fund. He believes that short-term yields are expected to rise more from the current levels and one must keep averaging at all levels for the next six months.  

A strategy of periodic averaging in funds like short-term debt funds should pay off well in 2-3 years. “It can be expected that in 6 months, the markets would have weathered the storm, and that could be a good time to add duration to the portfolio,” adds Bagla. 

Other experts agree with the strategy. “The possibility of RBI moving the benchmark repo rates to a pre-Covid level of 5.15 per cent exists. With the possibility of (more) rate hikes, investors in fixed income schemes stare at a possibility of low returns,” says Rahul Pal, head-fixed income, Mahindra Manulife Mutual Fund. 

Pal believes that the debt market is witnessing the “curate’s egg” phenomenon; part of it appears good and parts not so good. The latter part includes the shorter end of the yield curve which remains susceptible to the RBI rate action. However, parts of the curve above 5 years have started looking interesting. 

What Should An Investor Do? 

While crystal gazing is always fraught with risk, the classical way of solving an investment dilemma is to look at the investor’s risk appetite. An investor with adequate patient capital can potentially start looking at investing in a staggered fashion in short-term and dynamic funds. Investors with shorter investment horizons may look at liquid and ultra-short-term funds. 

They say the best returns are made when you invest with a sense of fear. The sense of fear is the highest for debt schemes now.
 

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