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Repo Rate and Liquid Funds

Do you think that the Reserve Bank of India will cut short-term interest rate like the repo rate in the near future? How will it affect debt funds? Will the impact be less severe on liquid funds?

What are the chances of a repo rate cut in the near future? How will it affect debt funds especially liquid funds?
—Neil Agshikar

Predicting whether it will rain today or not or predicting when Dr Reddy will cut the repo rate are things, which even the wisest of people cannot do with 100 per cent accuracy. So, we won't attempt to give you a date or time when interest rates will be cut, as we do not know.

But what we can do is definitely chalk out a plan so you reap the benefits of favourable developments, or shield your portfolio in adverse times.

First the basics. Repos are repurchase agreements done by various entities like banks, primary dealers and institutions either within themselves or with the Reserve Bank of India.

The rate at which these transactions are carried out is the repo rate, which is fixed by the RBI from time-to-time. Repo transactions are primarily aimed at maintaining adequate flow of money in the banking system. Since repo transactions have a very short-term maturity, the repo rate serves as a benchmark for all short-term maturity instruments.

Liquid funds or cash funds, where investors flock for capital preservation and easy redemption, invest in short maturity instruments like commercial papers or bonds issued by companies. The market value of these instruments is affected by changes in yields on short tenure government securities or a change in the repo rate.

Subsequently, the value of cash funds' portfolios, which invest in these instruments, is also affected. A rise in interest rate (or repo rate) results in a fall in prices of existing bonds and a fall in interest rates (or repo rate) leads to a rise in prices of existing bonds. Therefore, any reduction in the repo rate is likely to have a positive impact on cash funds also.

However, the magnitude of change will differ-the longer tenure bonds (gilts) register higher price appreciation when interest rates fall compared to shorter tenure instruments.

As liquid funds are at the shortest end of the maturity spectrum, they are affected the least. Thus, they benefit the least when interest rates fall and also suffer the least when interest rates rise. For example, when the repo rate was cut by 0.25 per cent in August 2003, long-term gilt funds and income funds gained the most-1.84 and 1.14 per cent, respectively, in a week. The weekly gain for cash funds was small at 0.09 per cent.

In a nutshell, any fall in key benchmark interest rates is likely to give a kicker to returns of all fixed income funds, with liquid funds gaining the least. But remember that interest rate cuts are just a one-time trigger. Ultimately your fresh investments in your fund will earn you lower income as the fund will be investing them at lower yields.

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