Most floating rate funds have under-performed liquid funds in past 6 months

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While the RBI is yet to hike the repo rate, yields on government securities have moved up sharply over the past six months: the yield on the 10-year bond is up 60-70 bps to 6.9%. Where are they headed in the next year and what will be the key drivers?

Normally, long-term bond yields move ahead of RBI policy action because they are more a function of evolving macro-economic fundamentals whereas short-term yields depend more on the RBI action in terms of liquidity and rate changes. So, the market has been expecting inflation and interest rates to go up. In India, there is a perceptible up-move in bond yields after the RBI stopped G-SAP (g-sec acquisition programme) in its mid-year policy. So, because the RBI is no longer buying g-secs and there has also been stable supply of g-secs, that’s why yields have gone up.

After the Russia- Ukraine conflict, there was a lot of apprehension in the market, crude prices went up and the bond markets also reacted to that. But, after the initial reaction, there is a certain sense of stability in the market for two reasons. One, the conflict has not become a wider global conflict and two, oil sanctions still exclude the supply of oil from the Russian companies. So, that has also helped. Therefore, people are expecting that this is supply shock-related increase in oil prices may not be very long-term in nature. There have been speeches from the monetary policy authorities to the effect that this supply shock inflation is not something that they can necessarily address and they are hopeful of supply side measures from the government, relaxation in taxes and not too much of an increase in oil prices. So, while yields have bounced up after the conflict but right now, they are in a stable range.

Also, we must appreciate that March has been a dormant month in terms of government bond supplies. Last year’s borrowing programme is complete. So, we will know if there has been any further upside in yields, once the new year’s borrowing programme starts.

As of this point, the only driver is the RBI because in the absence of its intervention, given the imminent resumption in supply of bonds and given the global environment and the price movements in the commodity basket, yields will tend to move up. So, the RBI would like to moderate the yields, therefore, it all depends on how much the RBI feels the need to support growth. At this point, the central bank guidance is clear, it is focused on growth and is confident of inflation coming down in next quarter or so. Even if you consider the Russia Ukraine conflict, then also the revised inflation projection would be in the 5-5.5% band which is well within the RBI target of 4-6%. Therefore, either if inflation goes up and global markets become volatile, then the RBI may have to step in. So, the supply of bonds is the one factor that will put pressure on yields. So, my sense is that, some practical pricing will happen and therefore, I expect the yield to go down to 6.25 – 6.50% by June.

What debt funds make most sense for investors, today?

Right now, there is too much volatility and since everyone expects interest rates to go up, they are crowding out the short-end of the curve. Therefore, the yield curve is steep. So, while rates may go up over the next year, the opportunity cost of waiting and not investing is also very high. Target maturity funds (TMFs) are a good product and they give return predictability. It makes sense to invest in them now. There is one other element, too. If you keep money in shorter-term funds for shorter periods, you will be subject to tax at your income tax rates whereas if you invest in a TMF for five years, then long-term capital gains tax benefit is available. So, there is a huge impact in terms of taxation.

Now, different people have different investment horizons and risk appetites. So, from an interest rate expectation point of view, low duration funds too, provide a good option. If you want to benefit from interest rate volatility, then banking and PSU funds look good for a 2-3-year horizon.

Mirae Asset MF launched its first TMF only last week. Why the late entry into this relatively safe and popular category?

There is nothing like late or early. One, if you look at the last one year, people have been expecting rates to go up but the RBI has maintained a very stable interest rate environment to support growth. Now, there is a possibility that over an extended period, rates may remain elevated. So right now, is a good time to invest in TMFs. Two, our target maturity new fund offer closed just ahead of the financial year so investors would have got one extra year of indexation benefit.

With companies having deleveraged and economic activity returning to normal, is it a good time to take credit risk?

Right now, there is a certain amount of optimism on credit as corporate India has deleveraged. However, challenges remain in the mid and the lower segment of the corporate sector because of formalization and digitisation of businesses during Covid. Now that economy is gaining traction, credit growth may happen and we have seen 8.5% growth over the past year. Personally, from a long-term perspective, I don’t credit risk funds have the potential to outperform on a sustainable basis. In credit risk, one needs to understand the dynamics of risk versus return in that category.

What is your view on floating rate funds in a rising rate situation? Do they really fare better than other funds, given that they largely invest in fixed rate debt papers and achieve their mandate through interest rate swaps?

No one can predict what is going to happen next. But if you look at the last six months until 15 March, where short-term rates have moved up, most floating rate funds have underperformed even liquid funds.

In India, there is a limited availability of floating rate bonds. When you are using overnight interest rate swaps, then you are taking on basis risk. So, for example, when we hedge, we expect that if corporate bond yields move by 50 bps then their price will move by the same extent in the opposite direction. What may actually happen is, that the cash bond rates move by 50 bps but the swap rates move by only 30 bps. This asymmetrical movement between the rate of the bonds and the swaps is called basis risk. The other thing is that, when you are buying a bond and doing a swap against that, you are receiving a fixed rate on the bond and paying a fixed rate on the swap and receiving a floating overnight rate. Effectively, then you are holding an overnight fund. A dynamic bond fund does the same thing – when rates are going up, it will convert to overnight and when rates are going down, it will move into corporate bonds. So, a floating fund is a dynamic bond fund in a different packet.

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