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Going The Fixed Income Way

Fixed income investors should understand that RBI’s shift on interest rate hikes will make longer-term debt more valuable…

I can’t really say how the stirring inflation vs growth fight that the Reserve Bank is fighting will turn out, but its impact on different types of debt mutual funds will certainly be important. When the general direction of interest rates shifts, then fixed income investors and the fund managers who run these funds change their approach to investing. This shift is happening right now and anyone interested in fixed income investing should understand what is happening and why.

The RBI has clearly said that interest rates are now on their way down, even though they haven’t yet started doing so. This has led to a redrawing of the basic landscape of fixed-income investing. At this juncture, the response of fixed income issuers and investment managers is driven by two parallel effects. One, there is an expectation that existing, longer-term debt will become more valuable. And two, those who need to raise long-term debt will much prefer to wait till interest rates have fallen.

As far as the impact on various types of mutual funds goes, the broad impact will be that investors can expect bond funds to do better. Within bond funds, better returns will migrate towards funds that invest in longer periods’ debt. For quite a while now, the interest of bond fund investors had been concentrated in short-term funds and in FMPs. Short-term funds always find favour when interest rates are high, or they are tending higher, or if the direction is uncertain. Under all these circumstances, shorter-term investments offer good returns coupled with safety. The safety aspect is important because when interest rates move up, longer-term debt loses value while shorter-term debt doesn’t do so, or does so to a much smaller degree. India has been in this situation of rising or uncertain situation for a while now and shorter-term funds have been the focus. That phase is over now and investors will shift to longer-duration bond funds. The other big shift that is possible is that in Fixed Maturity Plans (FMPs). FMPs are closed-end funds that are issued for a fixed period. In the immediate future, FMPs will be less in favour than longer duration bond funds. In fact, currently, fund managers are not favouring FMPs because they are unable to deploy the funds in FMPs at the kind of rates that investors expect. In anticipation of the fall in rates, debt issuers are loath to commit to FMPs and get locked into higher rates or in the current economic environment they are not confident of borrowing at high rates.

However, it’s highly doubtful that a huge and sustained shift downwards is something that debt investors can count on. The central bank hasn’t actually done anything yet. They’ve said that they will bring down interest rates but in the same breath they have also said that they’ll keep a close eye on inflation. Given the declining rupee and the variety of deficits that the country is running, inflation is hardly likely to become a thing of the past. Therefore, India is a long way from a significant shift in interest rates and can certainly not be said to be heading that way either.

The effects discussed above are the kind that serious debt investors should be concerned with. From the broader perspective of a small investor who wants to know about a general equity-vs-debt view, we are very much in a time when fixed-income options make more sense and only very long-term money should be deployed into equity and that too gradually.

The high rates of returns that are available to retail investors in bank fixed deposits as well as other sources like the Senior Citizens Scheme, post office schemes and NSC are here to stay. We are a long way from a fundamental shift in the attractiveness of these savings instruments.