Debt Mutual Funds Will See Capital Gains on RBI Rate Cut

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A lower interest regime will allow investors of these schemes to gain from rising NAVs

In India, mutual fund investors are aware of equity schemes that invest a major part of the corpus in stocks. In comparison, awareness about debt funds — which invest in government securities, bonds, money market instruments, etc — is less.

Even then, there are quite a few investors who put their money in these schemes, which work like a substitute for bank fixed deposits as they score more in terms of tax efficiency. As a debt scheme investor aiming to earn a steady stream of income, you also need to be aware of another aspect of these funds: The price appreciation of debt instruments in your scheme's portfolio.

In debt instruments like bonds, the price and yield are inversely related, that is when prices go up, the yields of the bonds go down, and vice versa (for a better understanding of this

Given the current situation in the economy, there is a strong expectation that the rate of interest would come down over the next few months. If that happens, your debt funds
would see capital appreciation in their portfolio. This, in turn, would also lead to a rise in the net asset values (NAVs) of your schemes. Usually, it is observed in the debt market that the longer the tenure of an instrument, the higher its price sensitivity to interest rate fluctuations, and vice versa. So, if interest rates in the economy are expected to fall, the fund manager would usually buy bonds with a longer tenure and sell the ones with shorter tenure.

Based on the interest rate scenario, the fund manager decides whether he should invest in long duration papers, with maturity of over 10 years, or short duration papers with maturity of around six months or so.

But his decision simply depends on the interest rate scenario. When the interest rate is expected to go up, the debt fund manager would invest in shorter duration papers, but if the rate of interest is expected to come down, he will invest in longer duration papers.

Interest rates usually go up when the Reserve Bank of India (RBI) hikes key policy rates like repo and reverse repo rates (repo rate is the rate of interest at which banks borrow money from RBI, and reverse repo rate is the rate of interest that these banks get when they keep money with the central bank), while a cut in these rates by the central bank leads to a decline in the rate of interest.

In its policy review meeting later in the day, there is a 50-50 chance that RBI will cut key policy rates to signal a lower rate in the economy. If that happens, the prices of bonds would rise, leading to a fall in yields from those debt papers.

The chance of a decline in interest rate in the near future also presents investors with opportunities to go for higher accrual and the potential for locking in yields at current levels, says a fund manager. It also gives investors the potential for capital appreciation once the interest rate starts falling, the fund manager adds.

Another important aspect you should be aware of as a debt fund investor is the credit ratings of the instruments that are in your fund's portfolio. The simple rule of the game is that for higher rated instruments that carry lower risks the rate of interest is lower than those instruments that have a lower credit rating (and carry higher risks).

Now, if for some reason the credit rating of an instrument goes up, people rush to buy that instrument, the price goes up and the yield goes down.

The reverse happens if the credit rating for an instrument is downgraded. Often fund managers also take a view on the ratings of debt instruments and try to get a higher return in their funds.

 

If you want to invest in debt funds for twothree years, you can opt for long-term income and gilt funds to gain from capital appreciation when interest rates start falling and bond prices go up. And if you are looking to invest for an even longer duration, then you should gradually increase your allocation of funds in open-ended bond funds instead of getting locked in FMPs

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