A rate cut by RBI always cheers up debt mutual fund investors. However, the Reserve Bank of India’s decision to cut its key policy rate by 40 basis points today is unlikely to bring much cheer to investors, who have almost given up on debt funds that are hit by a series of defaults, downgrades, and recently shutting down of six schemes by Franklin Templeton. However, the rate cut is positive for short and medium term bond funds, say debt fund managers.
The RBI announced a 40-basis-points surprise repo rate cut while maintaining an accommodative stance. The repo rate now stands at 4% from 4.4% earlier. The reverse repo rate has been reduced by similar basis points to 3.35% from 3.75% earlier.
The repo rate is the rate at which RBI lends money to banks. Banks offer securities to RBI and borrow money to meet their temporary liquidity mismatch.
Lakshmi Iyer, CIO-debt and head product, Kotak Mutual Fund, say the rate cut came earlier and the quantum was more than what was expected by bond market participants. “I think the markets were expecting this on June 6. A 40-bps cut is more than what the market anticipated. We have seen yields come down and I think this is a positive news,” she says.
Pankaj Pathak, debt fund manager, Quantum Mutual Fund, believes that it is clear that RBI is alarmed by the incoming data. “The RBI Governor mentioned a lot of data about core industries and PMIs etc. This must have forced RBI to take action out of turn. But the governor also said that the future rate action will depend on the growth and inflation data, putting a limit on the rate cuts,” said Pathak.
The 10-year government bond yield, considered the benchmark rate for the bond market, fell by 14 basis points after the RBI rate cut announcement. The 10-year benchmark yield fell to 5.88% from 6.45%, the level at which it was traded before the announcement.
Money market participants are sceptical about the positive impact of additional liquidity in the system. They point out that even though the banking system is awash with liquidity, banks are not lending money to companies at a cheaper rate. They point to the fact that the large amount of money parked by banks with RBI proves that banks are not in a mood to take any risk and lend the money to distressed firms at a cheaper rate.
This could be a negative for the debt mutual funds. Unless companies improve their financials, more downgrades and defaults are likely in the coming days.
“For the transmission to happen smoothly, RBI will have to make regulatory changes. Just cutting rates will not lead to a full transmission in the market,” says Pathak, referring to credit flow at lower rates to industries.
Lakshmi Iyer believes that the tone was positive and the bond market would be relieved by the surprise rate cut. “Liquidity and rate cut, both are a win-win situation for the shorter-end of the curve. The G-sec yields have come down, but there you are dependent on weekly supplies etc. In the short and medium term space, I think there is high scope for further compression,” she says.
Iyer doesn’t think the larger-than-expected rate cut would result in a rally in the longer duration bonds. Longer duration funds, especially gilt funds, benefit the most in a falling interest rate scenario. When a rate cut happens, the demand for bonds with a higher coupon or interest goes up. This pushes up their prices, and NAVs of schemes that hold those bonds.
“The long duration funds and gilt funds have already rallied in the last one year and they are sitting on double-digit returns. We believe that if investors are okay with volatility, they can choose dynamic bond funds at this point,” says Iyer.
Pathak says yields will go up and down, there will be volatility, but investors should stay their investment horizon. “Short duration is facing issues, but in a falling rate scenario, we don’t recommend investors to redeem. The broader trajectory of the interest rates continue to remain benign,” he says.