Last week, HDFC Bank and SBI raised their benchmark base rates. While that’s bad news for home and auto loan borrowers, as it will see their EMIs get steeper, the hike in rates is good news for investors in debt funds.

With interest rates close to previous highs, debt funds could prove to be a remunerative investment choice

An idea on where interest rates are currently will help you make an appropriate choice.

Short-term instruments

The RBI reversed most of the extraordinary steps taken in July, by cutting the marginal standing facility (MSF) rates further in the October policy. This has resulted in short-term rates normalising after the spike a few months back. With short-term interest rates coming down, funds focused on short-term debt (such as certificates of deposit or commercial paper) have gained. These funds have delivered close to 3 per cent return in just four months.

But there is still room for more correction in short term rates as currently, short-term rates are aligned to the higher MSF rate instead of the repo rate as it used to be.

This is because the amount banks can borrow through the repo window is capped. As full normality is restored by removing this cap, rates once again will align themselves to the lower repo rate.

Short-term debt instruments will then stand to gain further.

Road bumpy for long-term

On the other hand, the Reserve Bank raised the rates (repo) at which it lends to banks, for the second time in two months, in October.

Thus, yields on longer duration 10-year government securities (G-Sec) have risen sharply since the month of May. From a low of 7.1 per cent, the yields are have now hardened to 8.9 per cent. Bond prices and yields have an inverse relationship.

Thus, with rising yields, bond prices have corrected sharply. Gilt funds investing in G-Sec have delivered 4-7 per cent negative returns over the last four months.

So, what will determine where long-term rates are headed?

Since May this year, when bond yields were at a low, the RBI hiked the repo rate twice. This led to yields trending higher. As long as there is a possibility of further repo rate hike, the upward pressure on long-term yields will persist.

The rate hike itself is dependent on a number of factors — inflation, growth and currency. The September inflation numbers are far from comforting. If high inflation persists, then a further repo rate hike by the RBI in its next monetary policy in December cannot be ruled out.

On the flip side, GDP growth which is down to 4.4 per cent, presents an equally compelling reason not to hike rates. The joker in the pack is the rupee, which may nudge the central bank in either direction.

Currently, it is very difficult to predict the direction the rates will move in. Hence, it’s wise to refrain from playing the guessing game. For now, volatility in rates is certain.

Where to invest

So, given this outlook on rates for different durations, how should you invest in the debt market? Your risk appetite will determine that.

If you’re conservative, with a low risk appetite, short to medium term funds will be ideal. If your investment horizon is one to four years, then opting for high rated funds with shorter duration will help mitigate risk of rising interest rates. This is because these bonds mature earlier than longer term bonds, allowing the fund manager to re-invest as rates increase.

If you are willing to invest for a longer term and weather the volatility, invest in longer duration gilt funds. If rates increase further, longer duration bonds are locked in at a lower interest rate for a longer period of time. Thus, such investments tend to take a bigger knock when rates rise. But if rates correct hereon, these investments hold good. The risk here is thus higher — only if you can stomach that, and can part with your money for a longer time should you invest in long-term funds.

If you have already bought such long-term bonds or gilt funds, you can continue to hold them with a time horizon of 18-24 months. The 10-year G-sec is close to the previous 2011 high at 8.9 per cent. If there is a further rate hike, yields may go up to 9 per cent or a tad higher. But if you have a long-term horizon, you will stand to gain once interest rates come down.

Consider the track record of gilt funds in the last five years, when interest rates peaked twice in July 2008 and October 2011. The 2-year, 3-year or 5-year annual return on gilt funds has been 9-10 per cent. Quite the compensation, for the risk!

> radhika.merwin@thehindu.co.in

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