Amid the upsurge of the COVID, past years have been extremely tumultuous for debt markets. All began with the closure of 6-yield oriented debt mutual funds at Franklin Templeton. Frightened by this, many investors became risk averse, which led to huge outflow from the credit risk funds. Next came the liquidity infusion and massive rate cuts by the Reserve Bank of India (RBI) to meet the pandemic-stricken slowdown, where gilt and long duration funds were revealed. Of late, rising bond yields resulted in the mark to market losses in debt mutual funds.
Further added to this commotion was a change in strategies to generate profit from debt markets. All of you might have come across jargon like carrying, roll down strategy, barbell strategy, etc. Last year for a few months, investing in dynamic bonds to sail through the volatile rate of interest scenario became extremely popular. Next came the craze to invest in target maturity funds. All these certainly confused an amateur debt fund investor, whose major aim was capital safety and generation of satisfactory returns.
Here is an attempt to enlighten these novice investors. One thing must be clear from the start, as a retail investor, you must not change your strategy with the change in market condition. This is particularly true for debt mutual fund investors. Whether it is equity mutual funds or debt mutual funds, your strategy must be such that it can face the market ups and downs.
Negative returns mystery
For the past few months, a spike in bond yields made many debt mutual funds deliver dim or even negative returns over the short term. What happened here? For this, first, you must understand – the classic inverse relationship between prices and bond yields.
Bond yield can be obtained by dividing the rate of interest on bonds by their price. Thus, if the bond price declines, the yield rises. How will this impact the debt fund’s NAV? Fund’s NAV is derived from bond prices that it holds. Thus, if the prices of the bond fall, NAV declines, which shows a loss.
But what exactly led to the decrease in the bond prices? RBI announced the retraction of Rs 2 crore banking funds via a fourteen-day reverse repo session in January 2021. Next, banks were asked to take funds out of the debt market and park them with the RBI. Selling off in the debt market led to a decline in bond prices and upliftment in yields.
Moreover, higher than anticipated government borrowing schemes of nearly Rs 12 lakh crore for FY 2022 stated in the previous budget were a turner. It contributed to the upsurge in yields. Increased government borrowing results in a huge government bond supply. Easy bond availability lowers bond prices and causes a rise in yields.
What to do in such situations?
While many factors listed above are not under your control, the only thing you may do to counter the risk of the rising yields is to avoid investing in long duration bonds. In scenarios of rising yields, long duration bonds often are extremely susceptible and so are the debt funds investing in these bonds. Why is this so? This is because the bonds are likely to face a dramatic decline in prices. As the rate of interest increases, issuance of any new bond will offer higher interest and thus make the existing bonds less attractive because they hold lower rates of interest. Thus, there will be a correction in their prices. This will lead to the NAV erosion of the long duration debt mutual funds.