Investors in debt mutual funds emerged winners in 2016 as many of the funds posted equity-like returns for the year - thanks to demonetisation. As on November 21, 2016, the one-year trailing returns of various categories of debt funds (debt: gilt and medium-term and debt dynamic funds) were in the range of 12-17 per cent as per data available on Value Research.
After the government banned high denomination notes in order to tighten the noose around black money, banks received massive deposits of around Rs. 5 lakh crore in the first 10 days of the announcement, as people rushed to deposit their old currency notes. Slowdown in credit offtake led banks to deploy the money in government securities. The sudden surge in demand for government securities pushed their prices higher, leading to a fall in the yield (coupon rate divided by price of the bond), which is inversely related to price.
The yield of 10-year benchmark government bonds declined sharply to 6.3 per cent from 6.8 per cent during November 8 - 21. The category of debt: gilt and medium-term and debt dynamic funds delivered 2-3 per cent in around 10 days post demonetisation, when it usually takes them three to four months to deliver such returns.
The yields are likely to go down further, but the decline may not be as sharp. A. Balasubramanian, CEO of Birla Sun Life Mutual Fund, says, "As it is, we have seen the yield dropping by more than 50 bps in the last few days since the announcement of demonetisation, and it would further keep rates low as banks have cut deposit rates."
In the short term, comforted by inflation numbers, it is expected that the Reserve Bank of India (RBI) may cut the interest rate by more than (25 basis points) what is widely anticipated. This will also put downward pressure on the bond yields. "With the Monetary Policy Committee's reference to 125 basis points as neutral real rate, we expect RBI to cut rates by 50 to 75 bps to take the repo rate to 5.50-5.75 per cent," says Pankaj Sharma, Head, Fixed Income, DSP BlackRock Mutual Fund.
Experts believe that inflation is going to remain suppressed at least in the near future, given the fall in demand due to demonetisation making room for a higher rate cut by RBI.
"In the short term, the demand for goods and services will remain sluggish as people are short of cash due to withdrawal limits put in by banks. With poor demand, inflation is going to remain under control at least for the short term. But once the money comes back in circulation, people will start spending; inflation may go up," says S.P. Prabhu, Vice President and Head, Fixed Income, IDBI Federal Life.
A.K. Sridhar, Director and Chief Investment Officer, IndiaFirst Life Insurance, concurs. "Inflation will start going up once GST (goods and services tax) is implemented in April next year, as services which were not getting billed will start getting accounted for," he adds. However, what could be a possible threat to the rally in bond prices is the rate hike by the US Federal Reserve and RBI's liquidity management steps.
"Liquidity, we believe, will stay easy for a while until the government brings down restrictions on cash withdrawals. Also, the RBI has adopted a liquidity-neutral stance, and has already begun siphoning out excess liquidity by issuance of bonds. These two measures will keep bond yields from slipping further," says Dharmakirti Joshi, Chief Economist, Crisil. The RBI announced incremental CRR of 100 per cent for banks to suck out excess liquidity from the system.
Joshi foresees some upside pressure on yields if the US Federal Reserve raises its policy rate in December. "For now, Crisil expects the 10-year G-sec yield to settle at around ~7, with a downward bias, by fiscal 2017-end," he said.
How FDs and small savings schemes will shape up
Those who invested in fixed deposits in 2016 earned almost negligible returns after considering inflation and tax. As banks have slashed their fixed deposit rates post demonetisation, the effective interest rates have gone down further.
Experts believe that with credit yet to pick up, higher deposits will put pressure on fixed deposit rates, and they may fall further. "The bank fixed deposit rates may fall down to 6 per cent," Sharma of DSP BlackRock says. Currently, SBI offers 7.05 per on a one-year fixed deposit.
The fall in bond yields may also trigger a cut in the interest rates of small savings schemes such as public provident fund (PPF) and Kisan Vikas Patra (KVP), as the rates are now market linked. The interest rates on PPF are pegged to the yield of government securities of the same maturity with a mark-up of 25 basis points.
Where you Should invest
If you are a conservative investor who relies on bank fixed deposits for regular income, it is better to lock-in money in FDs now, as the rates will fall further. Also, senior citizens who invest in senior citizen small savings schemes - because they offer higher interest than FDs - should lock-in their money before the interest rates are revised (decreased).
However, experts believe that the younger generation, which has the ability to take some risk for better tax-efficient returns, should consider debt funds. "Existing investors in debt mutual funds should continue to hold their investment. Also, those who have idle cash in bank accounts should look at debt funds as one of the investment alternatives to deposits. In a falling or stable interest rate scenario, debt mutual funds create a better experience, given the fact that it creates capital gain as the interest falls," says Balasubramanian of Birla Sun Life Mutual Fund.
"We expect 25 bps rate-cut in December and 25-50 bps next year. In this backdrop, we believe investors may find debt mutual funds to be an attractive investment option as compared to traditional savings products," Sharma adds.
How to Go About It
The investment environment is perfect for debt funds. Debt funds that invest in government securities are expected to benefit the most in the falling interest rate scenario. However, these funds are most volatile in nature - the decline is as sharp as the rise in case of change in interest rate. Therefore, knowing when to exit is very important when it comes to these funds.
"Given the fact that debt mutual fund offers products that take different types of interest rate and credit risk, the investor should choose funds in a manner that it ties with the time horizon of his investment," said Balasubramanian.
Therefore, long-term investors should go for dynamic bond funds which invest in a variety of debt papers, including government securities, corporate debt, certificate of deposits, commercial papers, etc. The fund manager has the flexibility to churn the portfolio as per the changing interest rate scenario.