Interest rates are going to be volatile: What mutual fund investors can do (2024)

The Indian economy has been facing cyclical and structural issues for some time. Now the Covid pandemic has created new challenges. While the government is employing fiscal and monetary measures to contain the epidemic, given the government’s already strained finances,these are likely to create volatility in interest rates.

Experts believe there is a likelihood of a serious revenue-expenditure mismatch. While revenues are unlikely to pick up due to the nationwide shutdown that has affected trade and commerce, expenditure is likely to jump due to the additional spending of Rs 1.7 lakh crore to help low-income households. Credit market expert Fitch Solutions expects India’s fiscal deficit to jump to 6.2% of GDP in 2020-21, compared to the budget estimate of 3.5%. Lakshmi Iyer, Chief Investment Officer (Debt) & Head Products, Kotak Mahindra Asset Management Company, says, “Given the likelihood of a dip in revenues as a fallout of the lockdown, there is a high chance that state and central finances will be stretched. In these uncertain times, the situation may only aggravate. Demand-side levers – FPIs, mutual funds, insurance companies are also sporadic in nature.”

The govt’s expenditure is way more than the revenue earned

From the monetary policy perspective, the RBI is trying to support the economy through a series of rate cuts. In the last 20 months the RBI has reduced its repo rate (the rate at which it lends money to commercial banks) by a cumulative 210 basis points from 6.5% to 4.4%. The 10-year yield fell to 5.9% (intraday) after the 75 basis points repo rate cut in the last week of March, but the fiscal concerns reversed its downward movement.

The apprehensions of increased government borrowings are contributing to the upward movement of bond yields. Santosh Kumar Singh, Senior VP - Head of Research at Motilal Oswal AMC says, “Although 1-year bond yields are falling regularly with the repo cut, 10 -year yield has remained anchored to around 6-6.5%. The short-term rates are expected to fall further but the long-term rates may remain in the given range due to increased FPI selling and expectations of fiscal expansion.”

There are concerns regarding the funding of government expenditure. The government plans to raise Rs 4.88 lakh crore in the first half of 2020-21, which is 62.56% of its estimated gross borrowings of Rs 7.8 lakh crore. The increased supply of government securities is expected to push up bond yields. Bond prices and yields move in opposite directions and prices of the previously issued bonds react when the new bonds are issued at a revised rate.

Bond yields rising due to fiscal deficit concerns

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There are also speculations of debt monetisation where the RBI funds the expenditure by directly buying government bonds. However, direct monetisation comes with the risks of high inflation as it implies printing of additional money. Inflation occurs when too much money chases too few goods. India being a supply-constrained economy, there is a high probability that the additional money will channel into a price rise. “The government will have to spend for the current social obligations and we may see RBI printing money.” adds Singh.

The massive foreign investors’ outflows from the debt markets are also a cause of concern for the bond market. Foreign investors have dumped debt securities worth Rs 60,300 crore in the month of March 2020.

On one side, concerns like borrowings, inflation and FPI outflows are creating upward pressure on interest rates, whereas on the other hand, RBI measures like repo rate cut, long term repo operations (LTRO), and removal of FPI ownership limits in certain government securities are aimed at soothing long term interest rates. The interplay of these opposite forces is likely to create uncertainty in the movement of interest rates.

Such volatility can complicate the economic growth prospects by affecting both consumption and investment. There are implications for the equity markets due to the impact of interest rates on the equity risk premiums. The equity risk premium is the difference between expected returns from the equity markets and risk-free rate. Volatility in the government bond yields which is used as a proxy for risk-free rate will make such risk premiums erratic. Moreover, returns of long duration debt funds and the NPS scheme will also get impacted.

Investments in short term or low duration debt funds will prove effective as they are less prone to the changes in interest rates. “There will be a flight to quality and portfolios with high-grade corporate bonds could gain AUMs in the mutual fund industry. Accordingly, categories like banking and PSU funds and short term bond funds may find favour with investors.” adds Iyer.

Also, investors can consider dynamic bond funds to ride the interest rate volatility. The portfolio duration of these funds are dynamically managed by the fund manager depending on the future expectations of interest rates. These funds generate returns by churning debt securities of different durations.

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