The budget is all about trying to balance the government’s revenue and expenditure. The shortfall is met mainly by borrowing in the market through the issuance of government securities.
When the Finance Minister announced on February 1, a higher-than-anticipated borrowing program, yields on government securities shot up and their prices crashed. Corporate bond prices too went down in unison. Debt mutual funds holding these bonds suffered massive erosion in their value.
A quick sampling of debt mutual fund schemes revealed a loss in value across most durations. The higher the duration of a fund portfolio, the more sensitive it is to changes in interest rates. The fall in the net asset value of the funds has been in proportion to their duration. Gilt funds of longer duration were particularly hit. Even floating rate funds which are expected to benefit from the increase in interest rates were not spared. “Dynamic” bond funds have failed to display any dynamism in the face of rising interest rates.
Outlook for interest rates
The current spike in rates has been anticipated by most analysts. The future looks grimmer. Interest rates are driven by many factors like inflation, oil and commodity prices, government borrowing program, etc. All of them appear to point towards ever-rising interest rates. War too may be on the horizon in Ukraine, which may lead to a further jump in oil prices.
Central banks like RBI and the Federal Reserve are in a catchup mode with market interest rates rising while policy rates are yet to see action, though the latter appears to be inevitable.
This leaves both the government and the Reserve Bank of India, as debt manager to the government, in a quandary. A rise in interest rates will add to the borrowing costs for the government which accounts for 20% of the budget expenditure, being the largest component. If the RBI steps in to buy government securities through open market operations (which can lead to a fall in interest rates), that has the unintended consequence of adding directly to the liquidity in the system, which can exacerbate inflation.
A liquidity neutral “Operation Twist” by RBI which involves the purchase of long-term government securities (to bring down their yields) financed by the sale of short government securities may lead to a spike in interest rates of the latter. While this operation has been conducted in the past, and the market has been anticipating this for some time now, RBI has not resumed it yet.
Outlook for fixed income investing
The investment horizon appears to be bleak for the moment. Investing in securities/debt mutual funds with medium/high duration may lead to steep losses as interest rates rise. Even short-term funds of, say, one year (modified) duration would see a 1% fall with every 1% increase in interest rates.
The only investment which appears to be immune from changes in interest rates is the Overnight Fund category which today yields about 3.25%. Compared to the inflation rate of 5.6%, the real yield is negative. Liquid funds yields too are negative after inflation.
Floating Rate Savings Bond
The current pretax interest rate on these bonds at 7.1% beats inflation. The interest rate on these bonds issued by the government is reset once every six months. However, there is a lag between changes in the market rates and the rate revision on these bonds. Another complexifier (thanks to Jeff Bezos for introducing this word to us!) is the flip flop by the government a few months back, ahead of state government elections; the rates were slashed sharply only to be restored the next day.
It is quite possible that the government, having bestowed the largesse of interest rates higher than market rates in the past, will be in no hurry to increase them for some time. For investors in higher tax brackets, these bonds which carry a rate of 7.1% currently (till the next reset date), are fully taxable. At the 30% tax bracket, post-tax yield is 4.9% before surcharge, well below the inflation rate.
What can investors do?
Many mutual fund houses have been launching index funds with a portfolio of government securities (including state government) and PSU bonds, with target maturity dates in 2025, 2026, 2027 or 2028. The budget day massacre in bond prices witnessed a sharp erosion in the value of these funds. The Net Asset Value of some of these funds has now fallen below their issue price. However, the USP of these funds is that if investors hold them to maturity there is no capital loss.
Similar to a systematic investment plan (SIP) in stocks, investors can accumulate a portfolio of these target maturity index funds over a period of time, to minimize the impact of volatility in bond prices.
For investors in higher tax brackets, the tax benefit offered by debt mutual funds is a key differentiator compared to other investments like fixed deposits, corporate bonds, etc. Only gains above the inflation index are taxed, and that too at 20%, after a 3-year holding period. With short term debt mutual fund yields at around 4.5%, and the prevailing inflation rate of 5.6% it is possible that the entire return becomes tax-free. “Capital losses” can be carried forward to the future up to 8 years for setoff against future long term capital gains.
Investors can consider a mix of short term debt funds of about one-year duration and target maturity index funds accumulated periodically, in the face of a rising interest rate scenario.
“Mutual fund investments are subject to market risk” is not merely a statutory warning. The budget day massacre of February 1, 2022, and the even more traumatic ‘taper tantrum' episode of 2013 have amply demonstrated the interest rate risk in investing in debt mutual funds.
The only silver lining is that mutual fund houses appear to have learnt some hard lessons on credit risk after having burnt their fingers in investments in ILFS, DHFL, etc. Most debt mutual fund portfolios are now reflecting these lessons on the credit risk front, with relatively safer exposure in their current portfolios to bonds issued by PSUs or large corporates.
Given the current significant interest rate risk and lingering credit risk in debt mutual funds, investors in lower tax brackets can take refuge in Floating Rate Savings Bonds issued by the Government. An evergreen long-term, tax-free option is of course the Public Provident Fund which comes with an investment cap of Rs 1.5 lakhs a year at a very attractive 7.1% tax-free interest rate, though subject to periodic reset.
(The writer is a fixed income investor and erstwhile corporate banker.)
Disclaimer: the contents of this column should not be construed as investment advice or tax advice.
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)
