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Debt funds have lost heavily after the RBI tightened liquidity. Here's what you should do with your debt investments
As the Reserve Bank of India (RBI) brought down interest rates, his funds shot up almost 9% in just five months. However, a large part of those gains were wiped out when the RBI tightened liquidity in the debt market on July 15.
What lies ahead
With the rupee continuing to trade at around 60, the RBI's liquidity tightening steps may not end in a hurry. "The recent RBI measures may remain in force for a few months and yields may sustain at current levels till these measures are reversed.
In the worst case scenario, if the rupee continues to depreciate, the RBI may have to resort to more draconian measures that would hurt India's fragile economic growth. Several domestic and foreign brokerages have already cut India's GDP growth projections. Our current growth projection for 2013-14 is 5.6%, and the recent measures have increased the downside risk to it. Lower economic growth could result in FIIs withdrawing money from the equity market, where their investments are 10 times higher than in the sovereign debt market. The panic could then be more widespread.
The other, more optimistic, scenario being projected by market experts is that the RBI's basic monetary policy stance has not altered. Once the rupee stabilises (over the next 2-3 months), the liquidity tightening measures are likely to be withdrawn. Rate cuts could then follow after a gap. A focus on reviving economic growth should lead to lower interest rates across the yield curve in the medium term.
What should you do
Investors should either move to lower risk categories or stay put. Investors who can't digest volatility will be better off with short term and ultra short-term bond funds at this juncture.
The current fall in prices even spells opportunity. With securities in fund portfolios being marked lower now, the returns (via daily accruals) going forward will be relatively higher.
Experts are optimistic that investors will recoup their losses in due course. The losses that investors have suffered in their portfolios will be wiped out in the next 3-4 months. With interest rates having risen, debt fund managers will raise the average maturity of their portfolios. These will stand to gain whenever rates are cut next.
The advice to hold on to your long-term debt funds, of course, assumes that you have the necessary risk appetite and a holding period of at least 12-18 months. Let us turn to what your response should be in individual debt fund categories.
Liquid funds:
Do not redeem your liquid fund investments as whatever losses occurred after the July 15 tightening were likely to be temporary. Some retail investors who park their money in liquid funds for transfer to equity funds via systematic transfer plans (STPs) should also hold on.
Ultra short-term funds:
Though a decline in NAV dented historical returns, the return from this category should improve in the future due to the sudden jump in yield for maturity up to a year. Hence, investors should consider this as an opportunity to enter or increase their holdings.
Income funds (short-term and long-term):
This is the debt fund category that retail investors primarily choose. Since their portfolios have medium or long-term bonds, their NAVs took a severe beating. Several retirees park their money in these funds, especially in the monthly dividend option to get tax-free dividends. Many of these funds may not pay dividends for the next few months. Investors should shift out of the dividend option to the growth option and use systematic withdrawal plans (SWPs) to fund their regular monthly needs. The recent increase in dividend distribution tax (DDT) is another reason why they should do so.
Gilt funds (short- and long-term):
Though there is no default risk in these categories, the NAV volatility is the highest because government bonds are very liquid. The retail investors who entered these funds recently in the hope of gaining from falling interest rates would be sitting on losses right now. Investors should learn about the risks in these products and not invest in them based on hearsay or on the advice of someone who is not fully aware of the risks.
Exiting at this stage would mean big losses. Besides, interest rates may move down once the turbulence is over. Any rise in interest rates (and, hence, fall in NAVs) in the short term, if it happens, could even be an opportunity to invest an additional sum in long-term funds.
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