The evolving dynamics of debt funds

It used to be easy to make choices on investments, if one’s risk profile is limited go for debt investment while higher risk appetite explore equity investments. But recent asset volatility due to multiple reasons, including higher inflation, currency fluctuations and the ongoing war, has added additional momentum. The idea of ​​leveraged investments or fixed income securities as it is popularly called has also undergone a sea change with induced volatility due to the above reasons.

For more than a decade, falling interest rates, particularly in advanced economies, have suppressed all volatility and investment options have become rather transparent. These measures have also rubbed off on emerging markets as well as the cost of capital has been minimized. But the sudden turn of events after the pandemic led to an initial disruption of supply and demand, the excessive injection of money (especially in advanced economies) and later, due to the ongoing war, led to large price increases.

To counter the sudden surge in inflation, the US Fed began to change its monetary policy by raising interest rates sharply. This had the effect of exporting inflation from the earlier deflationary trend which began to exacerbate the rest of the countries. Most central banks, including the Reserve Bank of India (RBI), have resorted to raising rates not only to prevent inflation from escaping, but also to provide financial stability by controlling currency depreciation.

This created a difficult situation for investors as equity markets, despite being relatively resilient against global indices, remained stable. And the fixed income space has also taken a hit compared to the Covid period, i.e. over the last three quarters. The short term retained its appeal due to the withdrawal of liquidity and the tightening of interest rates. Although returns were limited, capital was pushed into this category. As the effects of rate percolation have a lag effect, the economy has slowly begun to show the negative impact of the continued prohibitive rate regime. The tightening continued and central banks persisted in their stance of fighting inflation rather than growth, it is understood that rates would stay higher for longer than initially expected.

This also indicated an interest rate cycle close to the peak in India (and most of the world), if not the actual peak of the cycle. This makes debt funds started to attract due to favorable higher yields in an inflationary world. Thus, this creates an opportunistic period for exposure to debt funds. The RBI’s target interest rates are 2% above the upper range of the 4% range, but the reality has been consistently above those expectations. While higher foreign exchange reserves for up to a few months gave the central bank a cushion to combat currency depreciation and growing current account deficit, the situation is no longer the same. The twin deficits (budget and current account), although the former peaked during the pandemic, also add stress to the central bank’s objectives. Credit growth is a big bright spot after years of moderate pace that also point to longer periods of higher rates, if not for a higher rate. The yield curve could top over the medium term with further normalization of the short end of the curve.

Investors who would like to take advantage of this situation could resort to floating rate funds which have an automatic coupon update with rate changes. This allows investors to take advantage of rising rates with this avenue. The other category that could benefit from the current situation are low duration funds as they too use a similar short-term strategy that compensates for interest rate increases during this period. The other strategy to benefit from this scenario is dynamic bond funds where there is a judicious mix of instruments that take advantage of spreads, i.e. bonds with ratings below AAA and floating funds which could become advantageous for investors.

(The author is co-founder of “Wealocity”, a wealth management company and can be reached at [email protected])

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