Rising bond yields impact: Debt mutual funds post negative returns

Debt mutual funds have posted losses across most categories in the last 1 month period, on the back of a steep rise in yields post announcements in Budget 2022. Bond yields rose sharply on Wednesday, after the Union Budget pegged the budgeted gross market borrowing for FY23 at a record Rs 14.95 lakh crore. The 10-year bond yield closed at 6.85%, from its previous close of 6.68%. 

Why are the yields rising?

• The bond yields are rising as the gross market borrowing forecasted by Budget 2022 is much higher than the market expectations that ranged from Rs 10 lakh crore to Rs 13 lakh crore. The concern is that this borrowing program will be very challenging for the market in a year when the RBI is expected to raise rates and absorb any excess liquidity.
• The investors fear that the central bank may now be forced to act on the inflationary risks, putting an end to a pandemic driven easy monetary policy seen so far. 
• A growth focussed Budget which announced capital expenditure of Rs 7.5 lakh crore for FY23, an increase of 35.4% from the last fiscal year, has also sparked fresh fears about inflation. 
• Global crude oil prices at seven-year highs and expectations for the U.S. Federal Reserve to raise rates more aggressively, have also led to investors bracing for an increase in interest rates going forward. 
• While the RBI’s has kept Repo rate at a record low of 4% since the beginning of the pandemic, the central bank is expected to tighten interest rates in the upcoming year. The consensus is that the RBI could increase rates by up to 75 bps in the upcoming financial year. 
• All of this collectively means that the yields could continue to rise in the future. 

Impact on debt funds

• Due to their higher sensitivity to yield changes, longer duration funds have been the worst performers in the last 1-3 month period. Duration is the measure of the sensitivity of a bond’s price with respect to changes in yields. The table below shows the performance of debt funds across categories
• Given a steep rise in yields, 10-year government bond yields have given negative returns of more than 2% in the 1 month period.

What should you do now?

• Stick to high-quality AAA-rated low duration funds and bonds. Prefer safety over high yields in this volatile market. 
• There is a significant tax advantage in holding a debt fund for more than 3 years. For a more than 3-year investment horizon, an investor should prefer short duration (duration < 3) fixed income instruments over long duration. 
• The interest rates are expected to bottom out and move higher over the next 3-6 months. Shorter duration funds are likely to outperform in this scenario, given their lower sensitivity to interest rate changes as compared to long-duration funds.