The Reserve Bank of India (RBI) has announced a host of measures to combat the ongoing economic slump and the subsequent financial crisis in the wake of the Covid-19 pandemic. The required liquidity injection through a series of rate cuts aim to boost demand in the economy, and give the much needed credit boost to the struggling industries.
There are three key takeaways from the RBI mandate that will augment the returns from medium to long duration debt funds. Let’s look at the three in detail:
- Repo Rate:
Repo Rate refers to the interest rate at which the RBI lends money to commercial banks. Overnight loans are disbursed at repo rate by the RBI. In the current monetary policy action, repo rate has been reduced to 4.40%, the lowest ever. As the interest rate falls, the bond prices increase, which in turn pushes up the Net Asset Value of the debt mutual fund schemes.
- Reverse Repo Rate:
Reverse Repo Rate is the interest rate at which the RBI borrows from commercial banks. When there is a surplus of cash with the banks, they park that money with the RBI to earn nominal, but fixed returns. The reverse repo rate has been reduced to 4%. As the reverse repo rate is quite low now , it is expected that the banks would look for other avenues to park their cash, such as bonds.
Since parking cash with the RBI doesn’t look attractive, banks will turn to high quality debt instruments with a 3-year maturity period. These kinds of debt instruments are majorly held by short-duration debt funds or banking & PSU funds, which may see a spike in their Net Asset Values, which will consequently boost the returns.
- Long Term Repo Operation
The RBI aims to drive a smooth credit flow in the corporate world through the Long Term Repo Operation. Through this, banks can borrow funds from the central bank for 3 years, at the same interest rate as repo rate (at which banks borrow on overnight basis). The duration of loan is crucial here as the benefit from low interest rate from RBI can be transferred to corporates and retail borrowers who borrow for a longer duration of time. However, the central bank has put a condition on long term repo borrowing. Whatever money the bank borrows from RBI under this operation, it is required to utilize the money in corporate bonds, commercial papers, and non-convertible debentures.
Since, there will be a high demand for corporate bonds, the bond prices of the bond paper held by corporate bond funds will rise, leading to a significant rise in the NAV of those funds. Consumers invested in these funds have a lot to gain in the coming year.
The aforementioned rate cuts will collectively lead to a jump in the total assets under management of the debt mutual fund schemes holding debt instruments with maturity periods ranging from 1-3 years. This rise in AUM will lead to a rise in NAV of the fund, leading to higher returns for the investors. The RBI has been giving a rate cut for quite some time now, whose effect can be seen in a gradual rise in the returns from debt funds. However, it should be noted that this is short term.
The volatility of bond prices will have a significant impact on the bond yields and the NAV of funds as well. Investors who wish to make substantial capital gains amidst the volatility can consider investing in Short-Duration Debt Funds, Banking & PSU Funds and Corporate Bond Funds.
Conclusively, we can say that a steep market correction has led to a fall in returns from equity funds, which are not expected to rise anytime soon, as the economy heads into a recession. On the other hand, debt funds are witnessing notable rise in the returns delivered, which make them a much attractive investment option right now. For the time being, you can consider investing in debt funds, and let the storm pass, before going back to equity funds.