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RBI keeps policy rates unchanged; have debt funds become unattractive? - Outside View by PersonalFN

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RBI keeps policy rates unchanged; have debt funds become unattractive?
Apr 9, 2015

Financial Year (FY) 2014-15 has been one of the best years for investors in debt mutual funds. Investors cheered improving fundamentals and invested aggressively in debt instruments, pushing bond yields down and bond prices up. Still there are many investors who missed out benefiting from the rally in debt markets. Some of you would still want to invest in debt mutual funds at this juncture. PersonalFN tells you if you can still make good profit on your investment in debt mutual funds.

We would first like to caution you about some common mistakes that investors make while investing in debt mutual funds. PersonalFN discourages any kind of speculation revolving around bond yields and / or interest rate movement. Moreover, PersonalFN believes that, you should invest in debt funds only after being sure of your time horizon. Maturity profile of the fund should ideally coincide with that of your time horizon. Many investors misjudge the risk associated in debt markets, thinking it to be safe and end up selecting wrong debt mutual funds. You should first identify the category of debt mutual funds that is ideal for your investment objective. And select your fund accordingly.

Now let us take a macro look to arrive at some possible scenarios in debt markets...

In its 1st bi-monthly policy for FY 2015-16 announced on April 07, 2015, RBI kept policy rates unchanged. The central bank has clarified that, its policy stance remains accommodative. However, in absence of smooth transmission of benefits of previous rate cuts to the borrower, RBI has preferred to maintain status quo for now.  For most part of FY 2014-15, credit growth of banks has lagged the deposit growth. Despite of that banks have not lowered lending rates. Also, lack of clarity on future trends in inflation has led the central bank keep policy rates unchanged.

RBI remains optimistic about economic growth prospects in FY 2015-16. According to RBI, declining retail inflation, commitment of the Government to increase spending on infrastructure, slack in commodity prices across the globe and upbeat market conditions are likely to improve the growth prospects in FY 2015-16. After bottoming out in November 2014 (4.38% on Y-o-Y basis), retail inflation has been going up steadily. Inflation measured by the movement of Consumer Price Index (CPI) stood at 5.37% in February 2015. Based on updated estimates of structural models and information revealed by surveys and market-based estimates, RBI appears to be confident of being able to maintain inflation below 6% target set for January 2016.

India's improved prospects on current account front and strong kitty of forex reserves are likely to provide India an edge over other emerging markets. Monetary policy normalisation in the U.S. is likely to result in outflows from emerging markets. However, India looks better positioned in comparison. Business confidence as well as consumer confidence has gone up in the recent past indicating optimism about recovery in India. Commitment of the Government to contain fiscal deficit within targeted territory would be tested as Government aims to attaining investment led economic recovery.  

Liquidity condition in the system has stabilised in FY 2014-15. It is evident from cooling credit off-take and higher deposit growth. Going by the latest figures, it is unlikely that, liquidity situation would be stressed in the immediate future. Banks parked close to Rs 29,300 crore in reverse repos in March while their borrowings remained stable.

What to expect?

The yield on 10-year benchmark bond declined by 72 basis points from 8.52% at the end of September 2014 to 7.80% by the end of March 2015. The fall was accelerated after crude oil prices came down sharply in the second half of FY 2014-15.

Going forward, such a drop in bond-yields is unlikely, due to following reasons:

  • Unlike then, markets have already factored in over-supply in the oil market. Possible positive impact on India's inflation as a result of falling crude oil prices has already been taken into account. There would be pressure on the market in case the trend reverses for unforeseen reasons.

  • Debt markets may start assuming RBI's optimism (to be able to maintain retail inflation below 6%) as a norm. Even a slight deviation from projection may have huge negative reaction from the market

  • Unseasonal rain has already damaged Rabi crop. There is a possibility of receiving sub-normal monsoon this year. Although it might be too early to be worried about that, markets would start reacting negatively if the possibility gets greater endorsements from weather forecasters. Food inflation has been a bigger contributor to the overall inflation of late.

  • If RBI sees any upside risk to inflation or witnesses delays in the process of monetary transmission, it might continue to maintain status quo for longer than expected. This may make investors anxious.

  • RBI would be watchful to the progress of Government on reform front. Performance of the Government would also be closely monitored as far as containing fiscal deficit is concerned. Effective utilisation of subsidies would also be watched out for.
PersonalFN is of the view that, path to further rate cuts may not be as smooth and linear as investors would have anticipated. Going forward, bond markets would be under pressure. Also, the reaction of foreign capital flows towards global events such as monetary policy normalisation in the U.S. and geo-political situation in Middle East and Europe also remains to be seen.

As mentioned earlier, PersonalFN suggests that, you should avoid speculating on the movement of interest rates. Comfortable liquidity condition and exaggerated rally in long maturity bonds, point at possibility of normalisation of yield curve going forward. Your investment in debt funds should be in accordance to your personalised asset allocation and time horizon. Do not misjudge the risk associated in debt markets. Beware! Debt mutual funds are not risk free.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.


The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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