Rate pause effect: Debt fund yields come off after year-long rally

Yield to maturity may remain range-bound

The yield to maturity (YTM) of short-to-medium duration debt mutual funds (MFs) have started to taper off, following the Reserve Bank of India’s (RBI’s) move to pause interest rate hikes. YTM — an indicator of future returns — was trending upwards, across categories, since the central bank kicked off its interest rate hike cycle in May 2022 to curb inflation.

According to fund managers, YTMs of most short-to-medium horizon schemes had started to come off their highs in March itself and went on to decline further in April. Meanwhile, the YTMs of longer horizon schemes had peaked last year and have moved to a narrow range since.

YTM is the annualised return a scheme will make if the underlying paper is held till maturity. Hence, they mostly move in line with the change in yields of the underlying bonds.

“Yields have come down by 20-40 bps (basis points) in April from the peak seen in March due to reduced supply in the new financial year, decision of Monetary Policy Committee (MPC) to pause repo rate  hikes after cumulative hikes of 250 bps in the last one year, and expectations of a softer inflation,” said Vivek Sharma, fund manager, fixed income, Nippon India Mutual Fund.

According to Lakshmi Iyer, chief executive officer (CEO), Investment & Strategy, Kotak Investment Advisors, one of the reasons for the decline in yields in April was heavy deployment of funds by MFs. And once this slows down, she expects the yields to rise again.

“In April, the predominant buyers of G-sec are largely MFs and foreign banks. This is because of the large inflows into debt MFs last month. This pace of deployment is unlikely to sustain and hence yields may go up a bit from here,” she said.

MFs received net inflows of close to Rs 40,000 crore into target maturity funds and active debt schemes — like corporate bond funds — amid an investor rush for debt schemes before the end of indexation benefits in April.

Overall, experts see the yields and the YTMs moving in a narrow range on expectations of a long pause in the interest rates.

“The MPC meeting broke its streak of rate hikes, surprising the markets and leading to effectively resetting market expectations and cooling off of yields. We are in a long rate pause period after the MPC meeting. As per our assessment, shorter end rates shall remain within a range,” said Manish Banthia, deputy chief investment officer (CIO), fixed income, ICICI Prudential AMC.

“Yields are expected to remain tight till liquidity remains tight. The RBI Governor has indicated that liquidity will remain neutral,” said Marzban Irani, CIO, fixed income, LIC Mutual Fund Asset Management.

However, the expectations of another interest rate hike cannot be completely ruled out, say some experts.

This, combined with the fact that the risk-reward equation still favours shorter-to-medium duration funds, investment advisors and distributors are advising their clients not to rush for longer horizon debt funds on fears of missing out on high yields.

“India’s monetary policy is partly driven by what US and European central banks are doing. If the US continues to raise rates aggressively, we might find out that the stay on interest rates was only a pause and not a pivot,” said Vishal Dhawan, founder and CEO, Plan Ahead Wealth Advisors.

“The medium-to-longer horizon debt funds will benefit at the mark-to-market level more than the shorter ones during the rate cut cycle. The mid part of the yield curve seems like a sweet spot right now from a risk-reward perspective,” said Rushabh Desai, founder of Rupee With Rushabh Investment Services.

At present, the yield curve is more or less flat and hence the average YTMs of all scheme categories are around 7 per cent. Short term funds were offering the highest YTM at 7.72 per cent.

“The corporate spreads in India have been below historic levels for a while now, we have started seeing normalisation of these spreads and hence corporate bond yields have moved up, despite a correction in government bond yields. 

This has led to YTM on shorter-to-medium horizon debt funds increasing, even as government bond yields corrected after the RBI rate pause,” said Alekh Yadav, head of investment products, Sanctum Wealth.