RBI rate cut on cards: Is it right time to invest in gilt funds?

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Published: April 3, 2019 4:49:07 PM

Gilt funds carry no credit risk as investments are mainly made in government securities, but the funds are exposed to interest rate risk.

debt mutual fund, mutual fund, MF, gilt fund, dynamic bond fund, Reserve Bank of India, RBI, RBI rate cut, RBI policy rates, CRR, repo rate, reverse repo rate, RBI Monetary Policy Committee, MPC, government bonds, government securities, Gsecs, interest rate riskThe interest rate decisions not only play a major role in level of economic activities and the growth rate of the country, but also affect returns on various investments.

The Reserve Bank of India (RBI) hikes or lowers the interest rate through various mechanisms like CRR, repo rate, reverse repo rate etc to control the inflation and boost the economy. Such decisions depend upon the state of economy and macro economic factors.

As the RBI’s Monetary Policy Committee (MPC) meets for the first bi-monthly policy statement for 2019-20 amid low inflationary pressure, industry and experts are expecting that the banking sector regulator may cut key lending rate to boost the economic activities as fears loom large about global economic slowdown impacting India’s growth prospects.

“With the subdued growth outlook and moderate inflation, the RBI does not seem to have any major reason not to cut the policy rate again during its next meeting. I think that the relevant question is whether the bank would cut the rate by more than 25 bps,” said Sujan Hajra, Chief Economist and Executive Director, Anand Rathi Shares & Stock Brokers.

The interest rate decisions not only play a major role in level of economic activities and the growth rate of the country, but also affect returns on various investments. As the government and the RBI issue new bonds and money market instruments in new rate, the changes greatly impact performance of funds like gilt funds, dynamic bond funds etc. Because, apart from interest income, returns of a debt mutual fund comprise of capital appreciation / depreciation in the value of the security due to changes in market dynamics.

For example, a bond has a coupon rate of 9 per cent (coupon rate is the rate of interest paid by bond issuers on the bond’s face value). If the RBI lowers the interest rates subsequently and new bonds are issued with lower interest rates, the bond with 9 per cent coupon rate will be traded in a premium rate in secondary markets. If the interest rate is lowered further, higher will be the capital appreciation, and vice versa.

The scenario will be opposite if the RBI hikes the interest rates. Higher than 9 per cent interest rate means capital depreciation for the bonds with 9 per cent coupon rate. More the interest rate hike, the higher will be the capital depreciation and vice versa.

Gilt funds carry no credit risk as investments are mainly made in government securities, but the funds are exposed to interest rate risk. Gilt funds generate higher returns when interest rates are falling, but the returns turn lower or negative when interest rates rise.

In fact gilt funds have already outperformed other debt funds after the RBI had cut the repo rate by 25 basis points (bps) or 0.25 per cent in February after a gap of one-and-a-half years. While the top gilt funds have delivered returns as high as 11 per cent, the average return of the gilt fund category was 8.3 per cent in last year.

With rating agency ICRA also expects a 25 bps rate cut, it may be a good opportunity for you to invest in gilt funds as a back-to-back cut in interest rate would provide a fillip in returns on such funds.

Central Banks around the world seem to be veering towards a policy of monetary accommodation, to combat the likely economic slowdown. It is highly probable that the soft inflation prints and lower than expected growth numbers in recent times also prompt RBI’s monetary policy committee (MPC) to reduce policy interest rates and/or change the policy stance from neutral to accommodative. In such a scenario bonds may rally briefly and therefore give a fillip to bond portfolios,” said Dheeraj Singh, Head of Investments, Taurus AMC.

However, before investing in gilt funds, you should be aware that in case the policy rates are hiked by the RBI, returns may even turn negative. Moreover, once the interest rate is hiked, RBI will take its own sweet time to reduce it when the economy reaches the peak and inflationary pressure eases.

Cautioning the retail investors, Jason Monteiro AVP – MF Research & Content at Prabhudas Lilladher Pvt Ltd said, “Long term bond funds, such as gilt funds, are highly sensitive to interest rate movements, which a retail investor may not be able to actively track. Thus, even though long duration bonds and Gsecs look attractive based on the expected monetary policy stance, retail investors should avoid taking an exposure if they do not plan to actively manage their portfolio.”

“A duration strategy works best when one is able to predict the direction of interest rates in advance, and thus is able to maximise the returns generated through the fund. The 10-year Gsec yield has already eased by 20 basis points to 7.27 per cent from 7.47 per cent about a month ago. In September 2018, the yield was hovering over 8 per cent. So, market participants have already priced in a dovish stance by the RBI. An investor who enters now would be a bit too late to capitalise on the rally that began a few months ago,” he added.

“So it’s best to avoid playing the duration strategy. It can also be highly risky if interest rates movements do not pan out as expected. A better alternative is to let the an experienced fund manager do this for you by investing in a dynamic bond fund,” Monteiro advised.

So, it is always better to take advice from a financial advisor or take help of a distributor before you invest in mutual funds, be it equity or debt, unless you are an expert in taking investment decisions.

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