Outlook of Debt Market for 2nd half of the Year 2022

 

Outlook of Debt Market for 2nd half of the Year 2022

We would begin the topic by covering basic concepts relevant to the readers for a better understanding of this article.

Sometimes, banks may need liquidity to take care of an unprecedented spurt in the withdrawal of funds by their account holders, or to maintain the prescribed limit of the Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR). In such situations, banks may have to take loans from RBI by keeping Government Securities (G-Secs) as collateral. At the end of the loan term i.e. either overnight or 7 days, the bank repurchases the Government Securities from RBI by repaying the loan amount along with a pre-decided interest rate called Repo Rate – which is the interest rate at which the RBI lends money to the banks. In case, the bank defaults in paying the borrowed money back to the RBI, the latter sells the G-Secs that were kept as collateral.

Regulating the Repo rate is one of the tools available with RBI to regulate inflation (called Hawkish monitory policy) and growth in the economy (called Dovish monitory policy).

Consider a situation where the economy is facing high inflation; the RBI will keep increasing the Repo rate with an objective to curtail part of available liquidity in the hands of consumers. 

With the increase in the Repo rate; banks have to pay more interest to borrow money from RBI. Banks in turn would raise the lending rate on the loans given to their borrowers. This move, leaves consumers with less money thus, reducing their purchasing power, leading to a decrease in the demand for goods and services - making them cheaper; eventually cooling down the inflation.

The rationale behind RBI’s decision to increase Repo Rate: Based on the assessment of the economic situation, the Monetary Policy Committee (MPC) of the RBI, decided to increase the policy repo rate under the Liquidity Adjustment Facility (LAF). The decision to tame the inflation was made in light of growing inflation, the ongoing war between Ukraine and Russia, high crude prices, and global commodity shortages. Besides, US Federal Reserve increased interest rates by 50 basis points to 0.75%-1% in the May 2022 meeting, thus impacting the markets across the globe.

The RBI wants to keep inflation under control, which is already close to 7%, as well as manage and monitor money flow into the banking sector. Therefore, RBI may continue to further hike Repo rates to reach the level of 6 to 6.50% by March 2023.

 

Effect of rising Repo Rate on Fixed Deposit:  The rate hike is welcomed by the deposit holders of banks and corporates, as fixed deposits have become an attractive option to invest with surges in interest rates.

 

Effect of rising Repo Rate on Debt Mutual Funds: Assume that a 10-year Government bond was issued at a face value of Rs. 100 at 8% interest (coupon) rate, which implies the yield in this bond is Rs. 8/-

If the Repo rate increases and the lending rate is increased to for example 10%, that would mean that the yield for the new bond issued will be Rs. 10 /-. This will reduce the demand for the 8% bond since the 10% coupon rate promises better returns.

Therefore, to make the former more attractive, the face value of the bond will be decreased to, say, Rs. 90/-. So, the yield for this bond now becomes 8.89% (8/90*100), which is higher than the original- making it more attractive.

Hence, an increase in interest rate is directly proportional to the yield and inversely proportional to the face value. This means that the Bond prices are inversely correlated to yield.  When interest rates and the yield goes up, bond prices decline (and vice-versa) resulting in mark-to-market losses for debt mutual funds.

After the RBI's announcement, the 10-year bond yield, which had been steadily rising in recent months, inched up to 7.40%. As a result, the net asset value (NAV) of debt mutual funds has fallen sharply, particularly for medium and long-duration funds. An increase in interest rates will have a negative impact on debt funds with a longer duration.

Conversely, a decrease in the Repo rate may make the debt schemes more attractive as it may increase the NAV of the debt schemes. The margin of gain will depend on the average maturity and the securities the scheme holds.

Effect of rising Repo Rate on Equity Market:  The Equity market typically goes down with the RBI's policy rate hike.  When there is plenty of liquidity, the equity market does well. If the RBI tightens the interest rates, the stock market is adversely impacted. Following the RBI's action, banks tend to raise their lending rates, thus making loans more expensive. As a result, companies will have to pay a higher interest rate to borrow money, indirectly impacting their liquidity position, and leading to a decrease in equity fund returns.

What should an investor do?

 

Looking at the inflation of 7%, the terminal Repo rate should stand somewhere at 6-6.5%. Therefore, investing in Corporate Fixed Deposits (choose only AAA-rated CFDs) would offer a better interest rate over the bank fixed deposit.

Invest in debt mutual funds if you have a large investment portfolio. Debt mutual funds are taxed at 20% with indexation if you hold the money for more than three years. If you are investing for less than three years, they don’t have any tax advantages and are taxed like bank deposits at applicable income tax rates.

If you decide to invest for three years or more, look at investing in the Corporate bond funds, and Banking & PSU funds. Also, investing in the Target Maturity Funds (TMFs) is a good option, as you need not worry if held until maturity, as are locked in at the yield at the time of investing.

 

Note on TMFs: These are passive debt funds that track an underlying bond index. Thus, the portfolio of such funds comprises bonds that are part of the underlying bond index, and these bonds have maturities in-line with the fund’s stated maturity. The bonds in the portfolio are held to maturity and all interest payments received during the holding period are reinvested in the fund. Thus, Target Maturity bond funds operate in an accrual mode like FMPs. However, unlike FMPs, TMFs are open-ended in nature and are offered either as target maturity debt index funds or target maturity bond ETFs. Thus, TMFs offer greater liquidity than FMPs.

TMFs are currently mandated to invest in government securities, PSU bonds, and SDLs (State Development Loans), thus, carrying lower default risk compared to other debt funds.

 

Author

Ajit Singh

Founder

Graded Financial Services | Quick Turtle | AskCred

Email: ajit@gradedfinancialservices.com