Investors shoudn't drop their guard, it's not the time to take credit risks

RBI action has averted duration risk, but defaults could mar debt fund returns

Retail investors nowadays regard volatility in their equity portfolio as a par for the course. However, turbulence of a similar magnitude in the fixed-income portfolio catches them off-guard. Many investors received a jolt last week when the average returns of several categories of debt funds, including those with a shorter duration which are purportedly safe, turned negative. However, strong action by the Reserve Bank of India (RBI) in its March 27 monetary policy helped debt funds retrieve lost ground.  

Bond prices had fallen and yields had shot up across the interest rate curve during the fortnight preceding the RBI action. The impact was more pronounced in bonds, with maturities ranging from three months to three years. The underlying cause was a sharp drop in liquidity. Experts attribute this to the massive withdrawal of funds by foreign institutional investors (FIIs). "FIIs have been pulling funds out of emerging markets, including India, and moving them into safer asset classes," says Arun Kumar, head of research, Fundsindia.com. They have pulled about Rs 52,910 crore from the Indian debt market in March so far.

According to R Sivakumar, head (fixed income), Axis Mutual Fund said: “FII selling in the debt and equity markets was a primary factor behind the weakness of the rupee, and that, in turn, caused bond yields to go up.” Factors like the year-end withdrawal of funds by corporates, dislocation caused by the Covid-19 crisis (with brokers operating from home), and mutual funds also selling to meet redemption pressure were other factors that caused yields to spike.

 

 

While the markets were expecting the central bank to intervene, the magnitude of the action came as a pleasant surprise. “The market was expecting a 50-basis-point (bps) rate cut, but it came in at 75 bps. The market was also not expecting a cut in the cash reserve ratio (CRR) or targeted long-term repo operations (TLRO), both of which also transpired,” says Dwijendra Srivastava, chief investment officer (fixed income), Sundaram Mutual Fund. TLRO, in particular, is expected to ease pressure in the debt market. “Participants now know that the market has a backstop facility. Liquidity can be created by banks borrowing from the RBI window,” adds Srivastava.

The RBI’s actions have already caused yields to ease. For bonds up to one-year maturity, yields have dropped 100-250 bps, while for bonds of three-year maturity, they have fallen by about 150 bps. Category average debt fund returns have also moved back (largely) into positive territory (see table).  

Even though the crisis in debt funds was short-lived because of RBI’s prompt action, retail investors cannot afford to drop their guard. They need to be especially wary of taking credit risks. With operations of many companies coming to a virtual standstill, there could be a spike in downgrades and defaults in the near future. “So long as you are in funds with high credit quality, you will be fine," says Kumar. Stay away from credit risk funds.

The safe zone to invest in is funds with average duration of up to three years. Rajesh Cheruvu, chief investment officer, Validus Wealth suggests investing in categories such as short duration, corporate bond, and banking and PSU funds in a staggered manner, provided you have a three-year horizon. Avoid long-duration funds. “Heavy government borrowing could cause problems at the long end of the curve later on,” says Srivastava. The rule to follow is that the average duration of the fund category you invest in should not exceed your investment horizon. If that happens, spike in yields of the sort seen last month could result in losses for you.