As widely expected, the RBI-led Monetary Policy Committee (MPC) unanimously raised the repo rate by 50 basis points to 5.4% on Friday. 1 basis point is 1/100th of 1%. The bond market sold off after the policy announcement with yields moving higher by 15-20 basis points across the curve. Given that bond yields have come down significantly over the last month, Pankaj Pathak, fund manager- Fixed Income, Quantum AMC, sees a possibility of a further rise in bond yields in the short term. Pathak expects the 10-year G-sec yield to find support around 7.5%. What does it mean for a debt mutual fund investor? Where should a debt fund investor invest given the rate hike and volatile debt market. Here's the RBI's 50 bps rate hike decoded for debt mutual fund investors.

The MPC also voted 5-1 to maintain the policy stance as "focused on withdrawal of accommodation while supporting growth." This suggests that the neutral level of the repo rate, says Pathak, is at or above 6% from where the last rate cutting cycle had started. So, the rate hiking cycle is not over yet.

Inflation to ease

The MPC also noted, says Dhawal Dalal, CIO - Fixed Income, Edelweiss AMC, the recent fall in crude oil and key commodity prices and their potential positive impact on the headline inflation since Q1FY23 as well as improvement in key macro-economic indicators. However, he adds that the MPC decided to play safe and maintained their FY23 average CPI forecast at 6.7% as well as FY23 GDP growth forecast at 7.2%.

Volatile Bond Market

The bond market gave up all their gains after the policy announcement and pushed yields of benchmark 10-year government bonds higher at 7.25%. As per Dhawal Dalal of Edelweiss AMC, it is closer to technically important level of 7.27%. Dalal expects G-Sec yields to remain volatile amid higher supply pressure, lack of immediate positive trigger and subdued sentiment, he says. "In case of 10- year government bond yields convincingly cross 7.27% level, then it will likely settle in its next trading range of 7.27-7.47% based on technical factors."

Where should debt fund investors invest?

Investors with a shorter investment horizon and low-risk appetite should stick to liquid funds to avoid volatility. "With an increase in short-term interest rates, we should expect further improvement in potential returns from investments in liquid and debt funds going forward," says Pankaj Pathak of Quantum AMC.

Liquid funds are a better option for those keeping their idle funds in bank accounts. Since the interest rate on bank savings accounts are not likely to increase quickly, believes Pathak, while the returns from a liquid fund are already seeing an increase, investing in liquid funds looks more attractive for your surplus funds. However, such investors should stick to the most conservative liquid funds.

Investors with a short-term investment horizon and with little desire to take risks should invest in liquid funds which own government securities and do not invest in private sector companies which carry lower liquidity and higher risk of capital loss in case of default, says Pathak.

Dhawal Dalal sees a great opportunity for long term investors to consider target maturity bond funds for better tax-adjusted returns.

Target maturity funds have fixed maturity date with visibility of returns and negligible credit risk. These funds will broadly invest in government securities, State Development Loans (SDLs), AAA rated PSU bonds and treasury bills.

Based on expected terminal repo rate of 6% amid declining liquidity surplus and imbalance in demand- supply dynamics of IGBs this year and beyond, Dalal expects the government bond yield curve to remain steep and yields to remain elevated in the medium-term. "This may provide an excellent opportunity for long-term investors to invest in target maturity bond ETFs or bind index funds maturing in 5 to 10-year segment for superior tax-adjusted returns," he adds.

He suggests that it will be prudent for investors to stagger their investments in 2-3 tranches, preferably after each MPC policy outcome, with a view to average-cost investing and mitigate policy-related uncertainties.

Investors may choose suitable target maturity funds based on their investment horizon. This should result in superior investment experience.

According to Pankaj Pathak, medium to long-term investors with 2-3 years holding period, may consider adding their allocation to dynamic bond funds. "This way investors will be able to benefit from higher yields on medium to long-term bonds," says Pathak. Dynamic bond funds have the flexibility to change the portfolio positioning as per the evolving market conditions. "This makes dynamic bond funds better suited for long term investors in this volatile macro environment," Pathak adds.

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