Floating rate funds best bet after RBI policy meet

It's turning out to be a tough period for the fixed income investors, especially since the last year-and-half period. Since the pandemic hit the world, there's a near-synchronous rate cut across the world by the central banks. As the aftershocks of the pandemic weren't clear, the govt's and central banks have responded in tandem to rule over the economic shock due to the lockdowns and social restrictions. The simultaneous fiscal and monetary measures across the world were unprecedented to say the least.

Now, that the vaccination is picking up and the virus impact is slowing down among the populations, the after-effects of pandemic-relief is being felt. The uneven opening up has resulted in supply chain disruptions leading to pent-up demand scouring whatever is available, thus inflating the prices of almost everything, from chips to coal and veggies to toys. With the interest rates kept artificially low (in order to not hurt the nascent growth), the savers are at the receiving end. Though, the recent RBI (Reserve Bank of India) monetary policy meet has acknowledged the plight of savers and so said that they've left the interest over the small saving schemes still attractive and above the rest of the instruments.

Investors looking for better juice out of their savings have been sidestepping beyond their risk tolerance and exploring riskier investment avenues. As the bank deposits have yielded lesser real (negating the inflation) returns, investors have been looking for options beyond these traditional avenues. Investors have flocked across various debt mutual funds (MF), some without properly knowing the workings, looking from their past performance of their returns.

Many investors assume investing in debt MF amounts to the fixed deposit methodology though most often it translates a better and tax efficient alternative. Unlike the comfort of fixed interest, the debt MF could be subjected to volatility depending upon the interest rate fluctuations and liquidity constraints. While the entire universe of debt MF is quite large, there are various options for the investors looking for better returns for a defined period of time at different risk profiles. So, the choice of investment is not too obvious option and has to be monitored or guided by a professional.

But similar to a bank deposit where the interest on a deposit is confirmed in advance at a fixed rate, a bond also issues a coupon (interest upon face value) which held till maturity would gain on it. However, unlike the bank deposits, the bonds could be traded and so when interest rates fluctuate, the yield varies. As the bond is traded, depending upon the demand, the price of the bond also changes. This could be at a discount or premium to the face value, similar to how a stock is traded. But, the interest on the bond remains same and so the return would depend upon the price at which the bond is traded, is called yield.

For instance, a bond with a face value of Rs100 with a coupon of 10 per cent gives Rs10 as interest. If the same bond is bought at Rs110, still the bondholder gets Rs10, however, the yield would now be approx 9.1 per cent. A debt MF has a collection of such securities which have differing yields and so one has to look at the YTM (yield-to-maturity) i.e., yield as of today if held till maturity to understand the possible return from the fund. The categorization of debt MF is done by the securities duration or tenure i.e., how long the maturity of the security is of. One has to ensure that their need (timeline) is in-line with that of the fund's to avoid any negative surprises.

In the shorter duration, bonds are subjected to the liquidity conditions while in the longer term, demand-supply influences the bond prices. Since the onset of the pandemic, RBI has infused huge amounts of money easing the liquidity conditions that in the recent meet, they have announced various measures to reduce the excess in the coming weeks. The current situation of the yield curve is hence steep.

Yield curve could simply be a representation of a graph of yields (return) of different bonds with varying maturity. Hence, on an x-axis the tenure of the bonds is depicted while the y-axis represents the return. In a steep curve, the yields at the near term are lower than that of those at the long end. As mentioned, the higher liquidity has created a pulled the yields at the lower end, the longer duration is being managed for now. However, the steepness of the curve in the medium term is higher than the longer term, providing an interesting opportunity in the 3-6-year time frame.

This is because the RBI is hinting at increasing interest rates in future, if not immediate and so locking in yields at lower rates isn't profitable. Instead, one could wait for the higher rates to evolve to invest, so the longer term finds less attractive than the short to medium-term. Moreover, with an aggressive government borrowing program and RBI acting benevolently, would try to influence the borrowing costs. One has to keep in mind that the bond market is very dynamic and the situation evolves on a continuous basis, so the opportunity can't remain forever while the roll-down (time towards the destination) also discounts it. That means, what appears a three year would shrink to two-and-half years in six months from now. So, for investors the options are limited with floating rate funds (though not completely immune to rate hikes) and an active duration strategy to ride out the situation. Investors could also consider accrual strategy to benefit from higher carry. Carry is the return harvested to an investor from holding a higher yielding security over a lower yielding one. It's assumed that markets in steeper yield curve offer higher levels of risk premia than those that are of less steep.

(The author is a co-founder of 'Wealocity', a wealth management firm and could be reached at [email protected])