Interest rates may have peaked and could fall - should you invest in debt funds now?

In simple words, a fall in inflation means that the interest rates can come down too; the gap between interest rates and inflation is called real rate of return. In other words, if RBI’s latest projections on inflation come true (the latest inflation numbers already show a drop), there is scope for interest rates to come down.

“RBI expects inflation to go down in foreseeable future. If the inflation remains within the band expected, then the real rates need to contract in the form of a cut in policy rates,” says Sujoy Kumar Das, head fixed income- Invesco Mutual Fund. He expects the rates to fall by 100 basis points in CY2019.

“It is time to be cautiously optimistic. Though it appears that the worst is behind us, one should not ignore the intermittent volatility arising out of factors such as trade wars, crude oil and domestic political developments,” says Mahendra Kumar Jajoo, head of fixed income, Mirae Assets Global Investments (India).

Though experts are of the opinion that the rates may have peaked, there is no consensus on timing and quantum of the rate cut. What does that mean for your fixed-income investments? The possibility of a cut in interest rates will weigh on the minds of the fixed income investors.

Put in another way, some experts do not foresee any rate hike in near future. “With food inflation continuing to remain low and international oil prices falling sharply, there is no significant upside risk to inflation in the near future. There is thus no case made out for rates to go up. There is however no case for rates to come down either since inflation is likely to remain at around 4% which is the MPC’s target,” says Ashutosh Datar, Mumbai-based independent economist.

What Datar means is that if inflation remains at current levels, the RBI may not find much merit in hiking interest rates. A possible fall - or even steady - interest rates make the case for investors to take a look at their debt and fixed income investments.

At the outset, avoid government securities (g-sec) and long-term bond funds. While g-sec funds invest their entire corpuses in government securities, long-term bond funds invest at least 80% in securities whose duration is at least SEVEN years. These funds look promising when interest rates fall, but they lose the most if interest rates suddenly start to go up again.

“Due to uncertainty in global factors there is no clarity on which direction interest rates will move in near future. In such a case gilt funds can bring in volatility in your portfolio,” says Pankaj Mathpal, founder and CEO of Optima Money Managers.

A look at the table below shows two scenarios. In the CY2008, when the interest rates were cut by RBI there was a rally in bond markets. That led to double-digit returns by gilt funds. In that period, short-term bond funds delivered 6.9%.

After demonetisation, the yield crashed. But they started going up soon till September 2018. In that period short-term bond funds gave 5.69% but gilt funds could deliver 1.39%.

The divergence in returns arises out of the movement in interest rates. If the investor’s view on interest rates goes wrong, then he may see volatility in returns offered by gilt funds.

Mathpal advises his clients to stick to short-term bond funds. Short-term bond funds can offer healthy risk-adjusted returns.

Sujoy Kumar Das advocates investing in short-term bond funds with around three years duration. Ongoing yields of around 9% offer a good entry point. These bonds are issued by entities from both public and private sector. Though these investments are seen as low risk, the returns are not guaranteed.

You can also invest in credit risk funds. “Elevated yields after the recent volatility owing to non-banking finance firm (NBFC) issue, offers a good entry point into credit risk funds,” says Das.

Recently there was a fear in the financial market that a few NBFCs may find it difficult to repay the money they borrowed. That made investors wary of investing in bonds floated by these NBFCs. It led to a fall in prices of their instruments that led to a spike in interest rates payable on these bonds. It also had some rub-off effect on the low-rated bonds across the industry. Even if the fear is moreover behind us, still the yields are not back to pre-crisis level. That throws an investment opportunity. It is like buying stocks at low prices after a crash.

But there is a caveat. Credit risk funds are risky bets and meant only for seasoned investors with a high risk appetite. Credit risk funds typically invest in bonds with rating AA and lower. The intention here is to earn a bit more return by taking a bit more risk. It means that the investors’ capital is at risk in case the issuer of the bond does not pay as per the schedule.

If you do not have a high risk appetite do not lose heart. You can still invest in a relatively less risky mutual funds and earn healthy risk-adjusted returns on your fixed income portfolio. “Banking & PSU bond funds make a good investment case where you get to invest in AAA rated bonds at good yields and very low expenses,” says Ashish Shanker, head investment advisory, Motilal Oswal Private Wealth Management. One may want to have a look at corporate bond fund as an investment option, however, they do come with credit risk.

If you do not want to take any interest rate risk, it is better to invest in fixed maturity plans (FMP). FMPs are mutual fund schemes with fixed tenure. “You can lock in at current yields by investing in FMPs maturing over three years,” says Ashish Shah, founder and managing director of Wealth First.

The fund manager buys bonds that mature in line with the maturity of the scheme. The rate contracted on the bonds in the portfolio remains the same till the bond matures. This ensures that the scheme pockets the same rate of interest even if the interest rate in the economy falls. These schemes are good investment options for investors in the higher income tax brackets.

The gains earned in FMP over three years are treated as long-term capital gains and taxed at 20% rate of tax post indexation. That reduces your tax liability compared to the investments in traditional fixed deposits. Below table explains the taxation of FMP.

However, by investing in FMP you sacrifice liquidity. The units of FMP are listed on stock exchanges, but they are rarely traded near fair value. Hence be prepared to hold on to them till maturity.