Debt Mutual Funds: Budget Day Massacre Leaves Debt Mutual Fund Investors Nowhere to Hide
When the Minister of Finance announced a larger-than-expected borrowing program on February 1, government bond yields soared and their prices crashed. Corporate bond prices also fell in unison. Mutual funds holding these bonds suffered a massive erosion in value.
A quick sampling of mutual fund plans revealed loss in value over most durations. The longer 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 was proportional to their duration. Longer duration gilt funds have been particularly hard hit. Even floating rate funds that should benefit from rising interest rates have not been spared. “Dynamic” bond funds showed no dynamism in the face of rising interest rates.
Interest rate outlook
The current rate hike was anticipated by most analysts. The future looks darker. Interest rates are determined by many factors such as inflation, oil and commodity prices, government borrowing program, etc. All seem to point to a steady rise in interest rates. War could also be on the horizon in Ukraine, which could lead to another spike in oil prices.
Central banks like the RBI and the Federal Reserve are in catch-up mode, with market interest rates rising while policy rates have yet to see action, although the latter seems inevitable.
This leaves the government and the Reserve Bank of India, as the government’s debt manager, in a dilemma. A rise in interest rates will increase borrowing costs for the government which accounts for 20% of budget expenditures, being the largest component. If the RBI steps in to buy government securities through open market operations (which may result in lower interest rates), this has the unintended consequence of directly increasing the liquidity of the system, which may exacerbate inflation.
A cash-neutral “Operation Twist” by RBI that involves the purchase of long-term government securities (to depress their yields) financed by the sale of short-term government securities could lead to a spike in interest rates on the latter. . While this trade has been done in the past, and the market has been anticipating it for some time now, RBI has yet to pick it up.
Outlook for Fixed Income Investments
The investment horizon looks bleak at the moment. Investing in medium/long duration securities/debt mutual funds can result in significant losses as interest rates rise. Even short-term funds with a (modified) one-year duration, for example, would experience a 1% decline for every 1% increase in interest rates.
The only investment that appears to be immune to interest rate changes is the Overnight Fund category which is currently yielding around 3.25%. Compared to the inflation rate of 5.6%, the real return is negative. Returns on liquid funds are also negative after inflation.
Floating Rate Savings Bond
The current pre-tax interest rate on these bonds at 7.1% beats inflation. The interest rate on these government-issued bonds resets once every six months. However, there is a lag between the evolution of market rates and the revision of rates on these bonds. Another complicating factor (thanks to Jeff Bezos for introducing us to this word!) is the government’s about-face a few months ago, before the state government elections; rates were cut sharply only to be reinstated the following day.
It is quite possible that the government, having granted the generosity of higher than market interest rates in the past, will not be in a hurry to raise them for some time. For investors in higher tax brackets, these bonds, which currently carry a rate of 7.1% (until the next reset date), are fully taxable. At the 30% tax bracket, the after-tax return is 4.9% before surtax, well below the rate of inflation.
What can investors do?
Many mutual fund companies have launched index funds with a portfolio of state securities (including state government) and PSU bonds, with target maturity dates in 2025, 2026, 2027 or 2028. The bond price massacre on Budget Day 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 Equity Investment Plan (SIP), investors can accumulate a portfolio of these target-maturity index funds over a period of time, to minimize the impact of bond price volatility.
For investors in higher tax brackets, the tax advantage offered by debt mutual funds is a key differentiator from other investments like term deposits, corporate bonds, etc. Only earnings above the inflation index are taxed, and that too at 20%, after a 3-year holding period. With short-term mutual fund returns of around 4.5% and a prevailing inflation rate of 5.6%, it is possible that the entire return will become tax-free. “Capital losses” can be carried forward for up to 8 years to offset future long-term capital gains.
Investors can consider a combination of short-term debt funds with a duration of around one year and target-maturity index funds accumulated periodically, in the face of a rising interest rate scenario.
“Investments in mutual funds are subject to market risk” is not just a statutory warning. The Budget Day massacre of February 1, 2022, and the even more traumatic episode of the “tantrum” of 2013 have amply demonstrated the interest rate risk of investing in mutual funds.
The only silver lining is that mutual fund companies seem to have learned hard lessons about credit risk after getting their fingers burned in investments in ILFS, DHFL, etc. Most mutual fund portfolios now reflect these lessons on the credit risk front, with relatively safer exposure in their current portfolios to bonds issued by PSUs or large corporations.
Given today’s significant interest rate risk and persistent credit risk in mutual funds, investors in lower tax brackets can take refuge in government-issued floating rate savings bonds. A long-term and tax-free option is of course the Public Provident Fund, which comes with an investment cap of Rs 1.5 lakhs per annum at a very attractive tax-free interest rate of 7.1%. , although subject to periodic reset.
(The author is a bond investor and former corporate banker.)
Disclaimer: The content of this column should not be construed as investment advice or tax advice.