Accrual funds: Rates are usually 150-200 bps more than bank fixed deposits

Indian bond market and debt fund investors have suffered reverses over the past six months. The interest rate cycle reversed in Q3, 2017-18, and started rising, after a long period when rates fell.  Crude oil prices started falling in September 2014 and by December 2014, the Reserve Bank of India (RBI) was in rate-cutting mode. The repurchase rate was slashed from 8 per cent to 6 per cent over the next three years.
 
But in August 2017, the RBI stopped cutting and the Monetary Policy Committee cited fears of rising inflation.  Crude prices have risen since then. Food prices have also risen. The Consumer Price Index has risen, with retail inflation moving from 1.5 per cent year-on-year in June 2017 to 5.07 per cent by Jan 2018, followed by a moderation to 4.45 per cent in February. 

 
Crude oil prices are expected to stay high through 2018 while food prices will be dependent on the monsoon. The RBI expects (assuming a normal monsoon) that inflation will stay in the range of five per cent. It is unlikely that the central bank will cut rates in the near future.
 

Unrestrained government spending has created another stress point for lenders. The fiscal deficit rose beyond targeted levels in 2017-18 and it is likely to stay high through 2018-19. Indeed, given highly optimistic tax collection projections for 2018-19, the fiscal deficit is very likely to exceed targeted levels (3.2 per cent of the Gross Domestic Product) through the coming fiscal, 2018-19. This means higher government borrowing will crowd out private sector credit and bond yields will stay high.

 
The bond market has already reacted by steadily driving yields higher. After falling from over 9 per cent in December 2014, to 6.2 per cent by December 2016, the yield on the benchmark 10 year Government bond rose to 7.2 per cent by mid-2017. It had spiked above 7.81 per cent in mid- March. Corporate bonds have similar trends of rising yields. 
 
The crisis in the banking system has also impacted commercial rates. The mountain of non-performing assets (NPAs) and more stringent norms for bad debt recognition has made banks cautious. Banks cannot lend much and indeed, commercial rate hikes seem on the cards.

 
All this adds up to higher interest rates and higher bond yields. That's bad for debt investors in general. As rates rise, the value of previous loans drops and so do the prices of bonds. Rising yields could also make foreign portfolio investors (FPIs), who have been major investors in the rupee bond market, less interested to park their funds in rupee debt. The risk for FPIs has also increased due to the weaker rupee, which leads to currency risks. 
 
Debt funds dealing in long-term and medium-term debt have had to absorb losses or made very nominal gains in the last two quarters. In 2016, long-term debt funds generated averaged returns of 16 per cent or more. In 2017, those funds earned just 2 per cent. Short-term debt fared better. But liquid funds returned just about 6.5 per cent in 2017.

 
It is unlikely 2018-19 will be any better for debt funds as a category. Liquid funds will be less affected and might maintain the current level of returns. But medium-term and long-term funds could go into losses.
 
In any event, debt investors would take on much more risk if they opt for debt funds versus fixed deposits. Targeting short-term debt would be the best strategy until the rate cycle reverses. Debt fund investors should look at liquid funds and short-term debt funds.
 
 They could also try taking on short-duration fixed deposits in order to roll over quickly if there are rate hikes.  But the tax impact of such switches could be considerable. The lock-in period for long-term status is three years for debt. Investors who choose to do multiple short-term rollovers could see reduced post-tax returns if they forego the lower rates of long-term capital gains tax (20 per cent post-indexation).

 
Another option for the debt investor is to look at accrual funds, which buy-and-hold bonds to enjoy the interest. Accrual funds are less volatile but they also have less upside because there is little chance of capital gain. Essentially, the investor is looking to earn the same rate of interest as institutional lenders and bond market players. That’s usually 150-200 basis points above the returns available from bank fixed deposits. This is also a reasonable strategy.