Whenever there is a change in direction of interest rates, the landscape of fixed-income investing undergoes a transformation.
Over the past 21 months, the Reserve Bank of India (RBI) has raised rates as many as 13x. Now the central bank has indicated that there will be no more rate hikes.
At this juncture, the response of fixed income issuers and investment managers is driven by two parallel effects. One, an expectation that existing, longer-term debt will be more valuable. And two, those who need to raise long-term debt will prefer waiting till rates start to decline.
What does that mean for debt fund investors? Within bond funds, better returns will migrate towards funds that invest in longer periods of debt. For quite a while now, bond fund investors courted short-term funds and fixed maturity plans (FMPs), which are closed-end funds issued for a fixed period.
Short-term funds always find favour when interest rates are on an upward slope or the direction is uncertain. In such circumstances, they offer good returns coupled with safety. The latter is important because when interest rates move up, longer-term debt loses value while shorter-term debt does not or at least to a much smaller degree.
That phase is over and investors must shift to longer-duration bond funds.
In the immediate future, FMPs will be less in favour than longer duration bond funds. In fact, fund managers are currently not in favour of FMPs because they are unable to deploy the money 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. In the current economic environment, they are not confident of borrowing at high rates.
However, it’s doubtful that a huge and sustained shift downwards is something that debt investors can count on. The RBI hasn’t actually done anything yet and is keeping a close eye on inflation. Given the declining rupee and the variety of deficits that the country is running, inflation is hardly likely to disappear. So we are a long way from a significant shift in interest rates.
The effects discussed above are issues that serious debt investors should be concerned with. From the broader perspective of a small investor who wants to know about a general equity-v/s-debt view, we are 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 available to investors in bank fixed deposits as well as post office schemes are here to stay. We are a long way from a fundamental shift in the attractiveness of these savings instruments.
* Rates will not drop immediately, but the central bank has signalled that rate hikes have come to an end
* Returns on short term funds will not drop immediately but eventually that is the direction they are headed in
* Investors in debt funds can now consider income funds which have been avoided all through the rising interest rate cycle
* Alternatively, dynamic bond funds can also be considered
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