Your Money – Inflation impact: Once RBI hikes interest rates, returns from debt fund to dip

November 03, 2021 1:30 AM

The slow down fears about the effects of the Covid-19 pandemic have subsided. Commodity prices including food and fuel prices have increased significantly and are still rising.

Only in the last one year inflation readings have started to increase.

Equity markets are within striking distance of all-time highs. The slow down fears about the effects of the Covid-19 pandemic have subsided. Commodity prices including food and fuel prices have increased significantly and are still rising. However, it is also a majority view that current phase of high readings of inflation is likely to be transitory. Monetary conditions like repo rates and systemic liquidity have to be maintained at abnormally accomodatory levels to support the real economy. But what if the central banks are wrong and inflation, instead of moderating, actually goes up?

Inflation risks
Theorists often compare the current economic conditions to those of a previous cycle, trying to devise strategies to survive or benefit in the current circumstances by drawing lessons from what had worked in the past scenario. Once in a while when reality belittles their expectations, newer theories emerge to explain the new realities.

Conventional thinking used to be inflation, or a general rise in prices, is caused by excess money chasing too few goods. Central banks tried to control inflation by raising rates and reducing the supply of money in an economic system. Such measures had the ill-effect of reducing demand for most goods in general, leading to lower economic activity and employment, a solution not acceptable to the political masters.

In the last few years, probably due to productivity gains or because of changing demographics, inflation has not been a cause of worry for most economies despite maintenance of super easy policies by central bankers. Only in the last one year inflation readings have started to increase.

Bond market investors
Should the bond market investors be bothered by high inflation as central banks are not looking to raise the rates?
If inflation expectations start rising, interest rates start going up. Higher rates lead to lower prices of long maturity bonds leading to diminution in value of fixed income portfolios. It is interesting to see that emerging market central banks have started increasing rates faster compared to the developed markets. Bond yields have risen sharply in most emerging markets in the last few weeks. It can be assumed that if a central banker keeps monetary conditions easy for longer than required, people start expecting that rates will have to be raised much higher in the future and maintained for a longer period of time in order to bring inflation under control.

Most investors in mutual funds have shifted to funds with relatively low maturities—like money market funds, short term funds, etc. Banking & PSU debt funds with roll down maturities are also a smart choice as the maturity. While floating rate funds should do better in rising interest rate scenarios, their annual returns are lower than those of short term funds by a solid 1%.

To summarise, it can be expected that RBI will soon start to normalise rates and eventually increase repo rates as well. The more they delay, the larger is the risk of crystallisation of inflationary expectations and hence the need to increase rates for a longer period. Investors are cautioned to stay invested in money market, short term or PSU funds to avoid large mark to market pain. As rates rise, the returns from debt funds will be modest. Avoid funds where the proposition is not clear and can’t be backed by performance in an adverse scenario.

The writer is CEO, Trust MF

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