Repo rate hike: Short-to-medium term debt mutual funds to turn attractive

The 10-year benchmark yield ended 2 bps lower at 7.49%, after it declined to 7.43% intra-day following the RBI announcement.

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The 5-year government bond fell 8 bps to 7.29%.

Debt schemes of mutual funds, especially the short-to-medium-tenure ones, will become attractive for investors, with the Reserve Bank of India (RBI) reversing its policy stance to hike interest rates. On Wednesday, the RBI increased the repo rates by 50 basis points (bps) to 4.9%. After two years of the pandemic and super-low rates, fixed-income instruments are set to become attractive again.

The 10-year benchmark yield ended 2 bps lower at 7.49%, after it declined to 7.43% intra-day following the RBI announcement. The 5-year government bond fell 8 bps to 7.29%. Investment officers FE spoke to believe that fixed-income products are set to provide much better accruals compared with previous two years, when interest rates had plummeted to multi-decade lows. This also impacted returns from bank FDs (fixed deposits) rates, but with the cycle turning, fixed income will become attractive again as the rate cycle has just turned and the up-move in rates will continue.

Akhil Mittal, senior fund manager at Tata Mutual Fund, said, “Debt funds are currently much better priced compared with previous two years. In fact, capital markets’ pricing for risk-free rate is significantly higher than most bank FD rates. So debt funds are expected to provide much better accruals. It would be prudent to invest in shorter duration debt funds as accruals are decent and duration risk is contained.”

Arun Kumar of FundsIndia said the three- and five-year G Sec yields are already near 7-7.3%, and they typically trade 70-100 bps above the repo rate, which means that the debt market has already factored in the repo rate at around 6.3%. “It’s a good time for people to gradually start looking at debt funds, especially those with three- to five-year duration, and mentally be prepared that over the next three to six months, you might see some bit of volatility, but over a three-year time frame, you will still end up making reasonable returns, especially when compared to current FD rates,” Kumar told FE.

Target maturity funds and floating rate funds remain among the top funds for investors in the current scenario, experts believe. Target maturity funds are less riskier in a rising rate scenario as they hold bonds until maturity, while floating rate funds invest in different types of debt securities with variable interest rates, simultaneously reducing the overall risk. Further, floating rate bonds benefit from rate hikes as accruals go up while effective duration remains very low. “Target maturity funds, floating rate funds and dynamic bond funds could be some of the categories one could look at currently,” Lakshmi Iyer, CIO (debt), Kotak AMC, told FE.

However, given the elevated inflation and geopolitical tensions, the longer end of the curve will continue to be avoided by investors, at least till inflation and commodity risks remain elevated. “Due to the uncertainty over expected inflation, high fiscal and current account deficit, longer end of the curve might continue to remain volatile,” Mittal said.

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