Tips for debt fund strategies to get gains from possible interest rate cut

The consumer price inflation, or CPI, fell to 5.52% in October, its three-year low. It was 6.5% last month and 10% in September last year. The trend, if it continues, may convince the Reserve Bank of India, or RBI, to go easy on its fight against inflation and reduce interest rates. It has increased rates by 75 basis points, or bps, since September 2013 to control inflation. However, it may wait to see if the trend is sustainable before taking a call on reducing interest rates. This despite the fact that the CPI numbers are below its target of 8% by January 2015 and 6% by January 2016.

Sonal Varma, India Economist, Nomura Securities, says the RBI may move towards flexible inflation targeting from 1 April 2015 and propose a lower CPI target (perhaps 4-5%) beyond January 2016. "The likelihood of a rate cut in the first half of 2015 is slim because of the RBI's concerns about rate increases in the US and their impact on debt inflows," says Varma.

Bond Yields

Irrespective of what the RBI does, market trends are clearly pointing at softening of interest rates. "Liquidity is turning positive. It will bring down short-term rates," says Rahul Goswami, CIO, Fixed Income, ICICI Prudential AMC.

Falling current account deficit, healthier government finances and stable rupee all point to the fact that interest rates will be much lower from current levels over the next two years.

This will help duration funds, that is, funds that are highly sensitive to interest rates due to the long tenure of investments held by them. Interest rates and bond prices move in opposite directions. A fall in rates/yields leads to a rise in bond prices and, hence, net asset values of bond funds. For instance, in 2003-04 as well as 2009, when 10-year yields fell to 5% levels, long duration funds gave returns in high double digits.

Fund Choice

"In this scenario, duration funds are ideal for those with an investment horizon of more than three years," says Goswami.

Investors with a shorter horizon of, say, less than six months can invest in ultra short-term funds. For six months to one year, they can look at short-term income plans as improving liquidity may bring down short-term yields. If the holding period is more than a year, accrual funds are ideal as current short-term yields provide a good entry point for earning high accrual income. Funds which follow accrual strategy generally buy short-term instruments and prefer to hold them till maturity to reduce the interest rate risk.

Ashutosh Khajuria, head of treasury, Federal Bank, recommends treasury bills, or T-bills, or certificates of deposit, or CDs, for up to one year as these are tradable and giving better returns than fixed deposits, or FDs, of banks and that too by taking less risk. For more than a year, one can invest in G-secs and top-rated non-convertible debentures, or NCDs, which can give good capital gains as well.

Investors also have the option of putting money in corporate deposits, which are offering better rates to account for the higher credit risk.

Most corporate bonds are debentures, that is, they are not secured by collateral. Investors assume not only interest rate risk but also credit risk, the chance that the issuer will default on its obligations. So, before investing, it is important to assess the credit risk and its potential payoffs.

Usually investors chase corporate FDs for an additional return of 1-3%. According to Gaurav Mashruwala, Certified Financial Planner, if the resultant value of money due to higher interest rates is not substantial, one should avoid these. "These companies are raising money from the market as they have not been able to borrow from banks or other channels," he says. Investors must be wary, especially now, because as market conditions improve, more companies will come out with FD schemes.

Anil Rego, CEO & Founder, Right Horizons, says before investing in a corporate FD, the investor should consider the company's creditworthiness to understand if it will be able to honour its commitments.

According to Anil Chopra, group CEO & director, Bajaj Capital, the Companies Act 2013 has put some restrictions on companies tapping people's savings. "Now only financially-sound companies with high credit rating can accept deposits. Also, stringent rules have been made to deter companies from delaying interest/principal payments or defaulting on them," he says.

Ideally, one must diversify and invest in three-four companies and compare returns at the post-tax level. Remember that when a bank defaults, you are insured for up to Rs 1 lakh. But if a company defaults, recovering money could be a long-drawn process.

One may also invest in corporate debt funds as here risk is spread across instruments and closely monitored. These funds are for those who want to invest for three-four years. The idea is that in an environment where the economy is recovering, some companies' credit ratings will improve as their fundamentals change for the better. So, a fall in interest rates over the next 18-24 months will increase net asset values of these funds.

One point we forget is real rates (interest rate minus inflation). According to Murthy Nagarajan, head, Fixed Income, Quantum Liquid Fund, there is no defined 'Real Rate' and central banks react only when real rates become too negative (hurting the saver) or too positive (hurting the borrower).

As for now, we believe that the RBI is clearly on the side of the saver and, hence, will keep rates high, he says. But at some time in the future, as India seeks to invest for growth, the RBI will have to do something for the borrower too, he says.