The Reserve Bank of India’s (RBI) surprise move to hike repo rate by 40 basis points to 4.4%, the first increase since August 2018, and expectations of further frontloaded rate hikes this year means debt fund investors would see a drop in net asset values as bond prices fall. However, short and mid-term fixed deposits rates will rise initially followed by long-term deposits.
Debt funds: What next?
As the interest rate was expected to increase, experts were advising investors for quite some time now to invest in debt funds with shorter maturity to ensure a reduced impact on their investment. Such an increase in the interest rate will affect existing investors of liquid funds, ultra short duration and low duration funds as the average maturity of these funds is short.
Harshad Chetanwala, co-founder, MyWealthGrowth.com, says the impact on gilt funds and longer duration funds would be higher and can continue to hurt further whenever the interest rate increases. “Anyone who wishes to start investing in debt funds can gradually start investing from this stage. If the investment horizon is medium or long term, then you can start considering corporate bond funds, banking & PSU and medium duration funds to build their portfolio, else continue to remain in short duration funds at present as well,” he says.
Similarly, Sandeep Yadav, head, Fixed Income, DSP Investment Managers, expects debt yields to rise further and suggests a three-pronged approach for investors. “Invest in low duration funds, invest in smaller tranches in longer duration products and invest in actively managed funds to weather the rate cycles.”
In a research note, Edelweiss Mutual Fund says investors with long-term fixed income allocation should probably wait till June MPC policy and allocate a portion of their surplus (25%) after the June MPC outcome and keep allocating 25% each after subsequent MPC policy outcomes in target maturity bond ETFs / bond index funds maturing in five to 10-year residual maturities depending on their comfort level. “This should help them average out their investments and earn attractive tax-adjusted returns if they remain invested till the maturity of these funds,” it says.
Go for floater funds
Investing in floater funds of mutual funds is a smart bet as these can act as a hedge against rising interest rates. Here, fund managers invest at least 65% of the fund corpus in floating-rate bonds where the duration is up to 1.5 years. The rest is invested in fixed-rate debt instruments. When interest rate rises, return on floater funds also goes up as the funds predominantly invest in floating rate instruments. These funds benefit when interest rates rise as the coupons on such instruments are adjusted upwards accordingly.
Floater funds are a new category and the AUM in this category is mostly dominated by corporates and HNIs. Retail investors must understand the default or credit risk before investing in floater funds. Also look at the portfolio of the fund and check the quality of holdings before investing.
While existing depositors will not gain if banks raise deposit rates, new deposits will fetch higher rates once banks hike their deposit rates. However, existing depositors should not go for premature withdrawals as banks charge 30 to 100 basis points of the interest rate as penalty.
Some banks have started raising their fixed deposit rates. Chetanwala says with the increase in repo rate, short and medium duration fixed deposit interest rates could also rise.
Brace for impact
Impact of rate hike on gilt funds and longer duration funds will be higher and can continue to hurt further whenever the interest rate increases.
Investing in floater funds of mutual funds is a smart bet as these can act as a hedge against rising interest rates.
New deposits will fetch higher returns as and when banks hike their deposit rates.