Yield surge hits debt funds after RBI hikes lending rate in surprise move

Investors should be ready for volatility in long-duration securities, say experts.

The yield on the 10-year government security (gsec) increased by more than 28 basis points after the Reserve Bank of India’s (RBI’s) on Tuesday raised the policy repo rate by 40 basis points to 4.40 per cent. The spike in yield has impacted the returns of debt funds.

Data from Value Research shows that average returns of medium- to long-duration funds and gilt with 10-year constant duration funds have registered a one-day fall of -1.19 per cent and -1.69 per cent. The quantum of fall in returns is less in shorter duration funds and liquid funds.

On Thursday, the 10-year gsec yields closed at 7.40 per cent against Wednesday's closing of 7.38 per cent. However, on Wednesday the yields had shot up by nearly 26 basis points, sending many schemes in a tizzy.

Debt fund managers expect more rate hikes going forward to put pressure on bond prices. Bond yields and prices move in opposite directions.

 “Market participants should expect at least a 35-basis point hike in June as well. It is likely to be a tough market for all asset markets. Indian bond yields (10-year gsec) could trade later in the range of 8-8.50 per cent,” said Sandeep Bagla, chief executive officer of Trust MF.

If the yields are likely to move up as expected by the fund managers than longer tenure bonds would be very volatile in the months to come. Funds having higher duration are more volatile due to the higher sensitivity to the changes in the interest rates.

Typically, the prices of fixed-income securities are dictated by prevailing interest rates. When interest rates decline, the prices of fixed income securities increase. Similarly, when interest rates are hiked, the prices of fixed income securities come down.

Debt funds managers are expecting further rate increases of 50-75 bps or more in the near term as RBI tries to tame the inflation.

The RBI’s surprise decision to hike the rates hardened the shorter end of the yield curve, too. “We maintain moderate maturity in our funds. Given the expected rate hike, the gradual reduction of liquidity, rate hikes by global central banks and substantial supply of government securities, we expect yields to further harden in future. Investors may consider shorter maturity funds and floating rate funds as they provide a hedge against a rise in interest rates,” said a note from Franklin Templeton MF.