Effect of RBI Rate Cuts and Downgrades on Debt Mutual Funds

The past week was eventful in India. With RBI cutting repo rates and changing its stance to a series of downgrades affecting debt mutual funds. These certainly affect the debt mutual fund market which is currently very fragile. What should the investors do now? Will it affect their portfolio in any way? Should new investors enter the debt mutual fund market now?

RBI Repo Rate Cut

RBI has cut the repo rate by 25bps, a third cut this year, totaling the entire cut to 75bps. While the rate cut was expected by the market, what they didn’t expect is the RBI to change its stance to ‘accommodative’ from ‘neutral’. The liquidity in the market has increased. It shows RBI has given importance to growth than inflation. The RBI has cut the projected growth rate to 7% and this combined with a shift in stance shows the concern of RBI towards the slowing economic growth. Change in stance shows the direction of interest rate and there won’t be any sudden surprise to everyone with a rate increase.

A rate cut is a positive note for the debt mutual funds. The debt mutual funds have already benefitted with 2 rate cuts this year and the third one is a cherry on the cake. The long-term and gilt fund have given 13% and 11.5% return over the past year and with further rate cuts, these funds will give a higher return.

Effect of Rate Cut on Different Debt Mutual Funds

Bond yields and bond prices are inversely related. With a fall in interest rates, the prices will go up. But that’s not the case with all the debt mutual funds. The overnight and liquid funds are negatively affected while the long duration funds are positively affected.

A rate cut doesn’t mean good news for all types of debt mutual funds. There are funds which are actually negatively affected by this. The overnight funds and liquid funds will see low yields due to a rate cut. The short duration funds are somewhat neutral to a rate cut. There are valuations gains but the reinvestment will happen at a lower interest rate. The corporate bonds funds and PSU funds will see gains mainly due to demand for AAA and AA rated securities.

For gilt, medium duration and long duration funds the gains come from both coupon interest income and appreciation in the value of instruments. When the interest rates go down the bond prices of higher coupons will go up, in turn, increasing the value of funds that hold these bonds. But these are also the funds that see a greater cut in their NAV’s during an increasing interest rate regime.

Downgrades in Debt Securities

Due to a series of defaults by bond issuers, the credit rating agencies have downgraded these securities affecting the debt mutual funds in the market. The trouble in the debt market started with the IL&FS fiasco last year. This was followed by defaults in payments by DHFL, Essel Group, Yes Bank and Reliance Anil Dhirubhai Ambani Group. These were degraded by rating agencies and this has affected the debt market.

Effect of Downgrades on Debt Mutual Funds

The Indian Debt market has seen net outflows since the defaults started. In May 2019, the net inflows fell by 42% compared to April. The net outflows stood at Rs1.20 lakh crore against the net inflows of Rs 70 thousand crores in May. This has resulted in the fall of AUMs of most of the debt mutual funds. With high redemptions due to increased risk, the AUMs of most of the funds fell. The recent DHFL default has wiped out the returns of several years. On 4th June the DHFL Pramerica Medium term Fund saw an AUM drop of 53%. Several other funds also saw an AUM drop of more than 10%.

With eroding asset base due to high redemptions, the asset managers are selling high liquid good quality securities. This has increased the portfolio concentration and risk. To curb this the fund is being merged. DHFL Pramerica fund house has decided to merge two large funds. The merger can be beneficial for small funds but the large funds are only increasing the risk for existing investors.

Can Side Pocketing of Assets Help?

DHFL Pramerica fund house has resorted to side pocketing of assets of two funds in order to protect the healthy assets from being redeemed. But having stopped the redemptions can encourage fund managers to take a little more risk. The assets that have been side pocketed can only redeem when the recovery has been made. The existing assets of the fund will continue to operate as a regular fund. So instead of the entire fund going for a toss the investors will have a part of their investments in good assets and the rest is side pocketed and can be treated as a bad debt till they are recovered.

What Should the Debt Mutual Fund Investors do?

Well, so there is good news and bad news for debt investors in the market. With the RBI rate cuts, the long duration funds and gilt funds have benefitted. But the downgrades show that long duration funds can be riskier.

The liquid fund and overnight funds are the least risky funds but they are affected by the rate cuts. Credit risk funds, gilt funds, and dynamic bond funds are most risky debt mutual funds (but not riskier than equity funds) but they are the most benefitted from rate cuts. So what should the investors do?

Go with AAA rated securities

The investors should stick to the short duration funds and funds with AAA and similarly rated securities. Look for funds which are short, medium or long duration funds which have AAA and similarly rated securities and invest in them. Avoid funds which have a concentrated portfolio with single issuers with close redemptions and stick to well-diversified funds which have AAA and similarly rated securities. If your existing investments are matching these requirements then well and good or its time to rejig your portfolio.

Keep monitoring the portfolio quality and portfolio concentration as an investment is not a one-time thing.

Happy Investing!

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