Last week, small savings rates payable for Jan to Mar 2018 were cut by 0.2%. As an investor, you feel unnerved and are thinking if there is something else that needs to be done to get the most of our of your investments. Should you invest in bonds / debt funds? If yes, where? What should be our approach towards debt funds in 2018?
Unovest caught up with one of the practitioners, Arvind Chari, Head Fixed Income & Alternatives with Quantum Advisors, to get some answers. Arvind has 14 years of experience in the Indian fixed income markets as a dealer, analyst, and portfolio manager. I personally follow his view sand writings a lot and today he has agreed to share the same with you.
Here are all the questions (in bold) and Arvind’s responses. Any emphasis is mine.
We have just stepped into 2018. Where are we headed with the interest rates? What’s in store for the next couple of years with respect to bonds?
In our 2017 outlook itself, we had cautioned investors that ‘the best of the bond markets are behind us, investors should lower their return expectations; capital gains would no longer be the driver of bond/bond fund returns, and investors should prepare for short term capital losses’.
It has quite played out itself, with bond yields rising and returns much lower than that of 2014/15/16.
Back then we had also mentioned that we do not see the Repo Rate falling below 6%. That’s where we are at now.
But now, we do not share the market’s anticipation that the Repo Rate will be hiked in 2018. Although, we expect inflation to rise from the current levels, we still expect it to average around the 4.5% level for 2018. At that level, with the Repo Rate at 6.0%, it would still be +1.5% positive Real Rate and thus the RBI will sound hawkish but not hike the Repo Rate.
We expect market interest rates to rise though, especially short term rates. As the demonetization led excess liquidity situation evaporates and liquidity moves into neutral situation, we expect short term rates of upto 1 year maturity to increase during the year.
Long term interest rates have already risen quite a bit and can rise more if the oil prices continue to increase plus the government increases fiscal deficit and boosts spending with an eye on the 2019 re-election.
So unless oil prices reverse materially, we do not see long term interest rates falling meaningfully and thus the outlook is cautious, but returns may improve slightly as the current interest rates are substantially higher than last year.
What role do interest rates have to play in investor investment decisions? How should an investor get a sense of interest rates and make investment decision accordingly?
It depends on whether you are borrower or an investor. Today, many of us are both. We invest our savings after having paid our home loan, car loan EMIs.
So lower interest rates gets us lower EMIs but it also reduces the income that we generate out of Fixed Deposits, Provident Fund and Debt Mutual Funds.
In the current scenario, where the RBI is more focused on inflation and targets it at 4%, we do not expect short term interest rates to fall below the 6% mark. At the same time, the Repo Rate wouldn’t move way above the 8% mark. So interest rates (the Repo Rate) in general will be in narrower band as against what we have seen in the last 15 years.
Fixed Deposits and other fixed income instruments like bonds, PF, etc. will also range between say 6% – 9% (depending on the maturity).
Home Loans, Car loans for a good borrower should range between 8% – 10%.
Since an average salaried investor already has some money lying in bank savings, bank fixed deposits and EPFO/NPS and these are all fixed income investments, while investing they should include these in their overall allocation and then determine whether do they require any more of fixed income return streams or do they need to look at Equities for their allocations.
What are kind of mistakes investors should avoid making with bond fund investments?
The first thing investors, especially retail investors, should remember is that bonds and bond funds are not fixed deposits. They do not generate fixed returns like a fixed deposit.
So bond funds are risky particularly if you do not understand the above.
The second dangerous aspect of bond funds is looking at last year’s returns and then investing. If last year’s returns have been good, like say in double digits, it means it has come about by falling interest rates and thus through capital gains on the bonds held. Thus when you invest this year, not only is the yield on your investment lower but for you to make money you expect, the yields have to fall further. That may not always happen.
The third thing is bond funds can also deliver negative returns in the short term. When interest rates rise, bond prices fall and so does your NAV.
Keeping this in mind, investors should look to invest in bond funds. Over a 3 year period on a tax adjusted basis, bond funds may deliver better returns than fixed deposits but with volatility and not in a straight line.
In bond funds, there are several categories right from Liquid Funds (as a surrogate to money lying in your savings account) to Short Term Bond Funds (which try to balance interest rate risk and yield) to Long term/Dynamic Bond Funds (which essentially try to deliver returns by taking on interest rate risk).
There is a new category called Credit Opportunities Funds, which invest in companies that do not have great financial strength and thus pay more interest rates on their bonds. We would recommend retail investors to avoid credit opportunity funds despite their seemingly higher return as well as advise investors to check the portfolio credit quality of other categories of funds also. We are seeing many funds with some suspect investments in the search for yield/ higher return.
Are there opportunities to invest in bonds directly vis-a-vis mutual funds? (say for someone with Rs. 1 crore to invest)
Tax Free bonds which came in 2014/15 were like the dream investment. It was from AAA rated PSU and with very high tax free coupons. They are still available in the secondary market but at lower yields. But they remain attractive for the highest tax slabs.
There are some retail public bond issuance by certain NBFC’s which are other options to buy bonds. Again in this, one needs to be careful as to who is the issuer. Always remember, higher the coupon/ interest rate on the bond; lower is its inherent credit quality.
Which debt/bond fund is right for the investors in today’s scenario?
For investors who are looking at debt mutual funds for their short term savings are better off investing in liquid funds. After a year of huge surplus, liquidity in the banking system is now close to neutral situation. We expect the liquidity condition to turn into deficit mode by next quarter. This could push short term interest rates higher and provide opportunity to re-invest the short term assets at higher rates/yields.
Since we do not expect RBI to cut interest rates, in this scenario, returns from liquid funds might improve over the last year and it could become a better surrogate to fixed deposits for short term savers. Choose Liquid Funds which do not take too much credit risk. Remember, liquidity is your priority and not returns.
Given that bond yields have increased quite a bit and are currently well above 3-5 year fixed deposit rates, one can look at investing in Dynamic Bonds. However, be ready to live with volatility and lower returns than fixed deposits in the short term.
What are your key takeaways for bond investing in 2018? Any further questions on your mind? Do share with us.