The Reserve Bank of India in its recent policy announced that it will provide 1 to 3 year money at policy rate i. e. 5.15% to banks under long term repo window. This means banks can get upto 1 lakh crore at 5.15% from RBI. This has impacted bond yields sharply, particularly short term yields, which fell by almost 30 bps in last 2 days.
This hopefully will increase the pace of transmission of earlier rate cuts, and banks may cut rates on their new and existing loans. Despite 135bps rates cuts by RBI loan rates have not fallen in last 2 years. This was the major worry for RBI and with its new trick it hopes to solve this problem. Economy needs lower lending rates desperately to boost consumption.
This however also means that new investments in debt funds, particularly ultra short term, low duration and short term funds will see a drop in returns due to RBI’s action. FD rates shall also come down in coming quarters. The option for investors is to go up the maturity curve to earn higher yield by investing in long duration funds. However, this comes with its own cons. Long duration funds may earn you higher yields but the price risk which they carry doesn’t compensates the higher yield. If bond yields rise from here, long duration funds may incur losses as bond prices may fall.
It is wise to remain invested in low duration funds or short term funds now. Interest rates may bottom out in near term, and when they start rising again, these funds can reinvest at higher yields and may fare better than long duration funds. Do not get lured by current higher returns in long duration funds and shift your investments.
Another opportunity to earn higher returns may lie in funds that invest in AA rated bonds. Since AAA rated bond yields have fallen, investors might start chasing AA rated bonds and spreads may fall. However, given recent accidents in debt funds one needs a heart of steel to take this bet. I would not encourage to take this bet.
Now blame RBI for lower returns in your debt fund or be happy if you have a loan which might just pinch your wallet lesser in coming months.