Rising bond yields hit debt funds: What should you do now?
Debt mutual funds have posted losses across most categories in the last 1 month period, on the back of a steep rise in yields. Bond yields have soared past 7% for the first time in 3-years. We look at why the yields are rising, their impact on debt mutual funds, and what investors should do now.
Why are the yields rising?
- India’s 10-Year government bond yields have surged past 7%, the highest since May 2019, as the RBI signaled a hawkish shift in its policy outlook. The RBI has guided for withdrawal of its accommodative stance seen so far.
- The RBI has said that the focus is now shifting to inflation control rather than growth.
- Rising crude prices, signals of interest rate hikes by the US Federal Reserve have also contributed to the rising of bond yields in India.
- The RBI has also raised its inflation forecast to 5.7% in FY23 from 4.5% for FY23. It has also cut its GDP growth estimate to 7.2% from 7.8% earlier.
- Retail inflation soared to a 16-month high of 6.95% in March-22, as compared to analyst estimates of 6.35%. This will be the third consecutive time when the CPI inflation comes in above RBI’s upper tolerance band of 6%. Inflation has been on the rise due to a steep rise in food prices.
- “We maintain our longstanding view that the first repo rate hike will likely be in the August policy with the MPC changing its stance to ‘neutral’ in the June policy," Kotak Institutional Equities said in a note. 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 1.25% in the last 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 a long duration.
- The interest rates are expected to 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.