The supply chain disruption caused by the COVID-19 pandemic, as well as the lingering conflict between Russia and Ukraine, have caused prices of most goods and services (particularly food and fuel) to soar globally.
To tackle the elevated inflationary pressure, central banks across nations have resorted to aggressive rate hikes. Since April 2022 till now-, the US Federal Reserve cumulatively hiked interest rates by 375 basis points (bps). It has committed to bringing inflation to its target of 2%. Meanwhile, the Bank of England has hiked interest rates by 290 bps since December 2021.
In India too, retail inflation has persisted above RBI’s upper threshold of 6% for the past nine consecutive months. The RBI has so far hiked interest rates by an aggregate of 190 basis points.
The outlook for inflation and the path to interest rates
While inflation has declined from its peak, it continues to be at elevated levels and remains a key concern for policymakers. This indicates that global central banks will continue to hike interest rates until the prices are well under control.
India’s 10-year bond yield is trading close to 7.5% mark on the back of rising global yields, higher-than-expected domestic inflation, tighter liquidity conditions, and a hawkish monetary policy by the RBI.
We expect central banks to continue to hike rates though the pace of hikes may slowdown.
With elevated global and domestic inflation, synchronised monetary policy tightening in advanced economies, and adverse demand-supply dynamics in the domestic bond market, the macro backdrop is not supportive for bonds.
That said, the positive side is that much of the macro worsening has already happened and is now part of the collective market psyche. We have already seen the worst of inflation, and many of the rate hikes have already happened. The peak of central banks’ hawkishness is now behind us.
Looking forward, inflation momentum is expected to fade. The rate hiking cycle is nearing its end, and this should bode well for bonds.
The bond market globally has already pricing for aggressive rate hikes. So, bond markets may not move in sync with the central bank tightening. As the monetary policy stabilises, the yield spread between long-term bonds and the repo rate should compress. So, we see limited upside on yields from here.
We expect bond yields to move sideways in a tight range, with the 10-year G-sec yield trading between 7.2%-7.6%. At the same time, Short term money market rates will move higher along with the policy repo rate.
Why it makes sense to invest in a Liquid Fund now
Short term interest rates have move up a lot more than longer term rates due to combined impact of increase in the repo rate and tighter liquidity condition.
During the Covid-19 pandemic, the RBI had flooded the banking system with liquidity and set the the reverse repo rate (rate at which bank used to park their surplus funds with the RBI) 65 basis points lower than the policy repo rate as against pre-pandemic gap of 25 basis points. This kept the short term money market rates such as interest rate of upto 3 months treasury bills, certificate of deposits, commercial papers etc. much below the repo rate.
This dynamics has changed now. In the April 2022 monetary policy, the RBI introduced a new tool – Standing deposit facaility (SDF). Instead of the reverse repo, banks now park their surplus funds with RBI under SDF. The SDF rate is set at 25 basis points below the policy repo rate. This effectively pushed up the floor for money market rates to 25 basis points below Repo rate from earlier 65 basis points below repo rate.
Though, the RBI has raised the repo rate by 190 basis points, the floor policy rate has been hiked by 230 basis points since April 2022.
Additionally, the RBI has also drained the liquidity surplus available in the banking system by hiking the cash reserve ratio from 4% to 4.5%, selling government bonds and foreign exchange and not providing any additional against increased cash withdrawals.
Banking system liquidity (adjusted for government’s cash balance) was in surplus of around Rs. 7 lakh crore at start of the year. Recently in most part of October, liquidity was in minor deficit of upto Rs. 50,000 crore.
The combined effect of all these measures are that short term money market rates have moved up around 280 basis points since start of the year. The 3 month treasury bill, which was trading near 3.6% at start of 2022, is now trading above 6.4%.
Liquid funds invest in debt security with upto 91 days maturity. So, the portfolio yield of liquidity funds and their future return potential have improved significantly over the last few months. While on the other hand, banks are reluctant to increase the interest rate on saving account and short term fixed deposits.
This makes the liquid fund relatively better placed for your short term surplus cash.
Domestic demand-supply imbalance is the biggest worry for the long end bond yields. Therefore, it is important to tread with caution when you invest in long-term debt mutual funds. Overall, it is a good time to consider gradually moving into duration funds to build a long-term debt portfolio.
Considering the duration-accrual balance, the 3-5 year segment remains the best play as core portfolio allocation. Notably, valuations at the longer end bonds up to 10 years have also turned attractive after the recent sell-off. For longer term fixed income allocation, one can go with dynamic bond funds.
However, investors with shorter investment horizons and low-risk appetites should stick with Liquid Funds. With the increase in short-term interest rates, we can expect further improvement in potential returns from investments in Liquid Funds going forward.
The interest rate on savings bank accounts is not likely to increase quickly in line with a rise in policy rates. On the other hand, the returns from the Liquid Fund are already seeing an increase, making them an attractive proposition for debt portfolio.
The inflation trajectory is clouded with uncertainties amid concerns about geopolitical tensions, which has also made global financial markets nervous. In such an environment, Liquid Funds can help you avoid any sharp volatility.
Liquid Funds are an excellent avenue to manage your liquidity needs. These funds typically invest in government securities, certificates of deposit, debt and fixed-income securities that are highly liquid, thus offering safety to the portfolio. This makes Liquid Funds a suitable avenue to park your emergency corpus.
Liquid Funds can help you create a portfolio consisting of an optimal mix of equity and debt to help you earn reasonable risk-adjusted returns. For instance, if you are a risk-averse investor, your portfolio should consist mainly of debt mutual funds such as Liquid Funds, as these funds carry interest rate risk and credit risk. The rest can be in Equity funds, Hybrid funds, and Gold.
Liquid Funds can also help you rebalance your portfolio in line with changing financial conditions as well as market conditions. For instance, if your financial goal is nearing, or if your equity allocation has breached the upper end of the targeted allocation amid a market rally, you can consider gradually shifting allocation from your equity mutual fund investment to low-risk avenues such as Liquid Fund by setting up a Systematic Transfer Plan (STP). By doing so, you are able to safeguard your corpus from the impact of any steep market fall or intense volatility.
Similarly, if you have a lump sum amount to invest in equity mutual funds but are wary of market correction/high valuations, you can park your money in a Liquid Fund and then set up an STP to gradually transfer the investment to equity-oriented mutual funds of your choice. This way, you mitigate the risk involved and won’t have to wait for the right opportunity to enter the equity market.
When you choose Liquid Funds, it is advisable to opt for schemes that strictly follow the principle of safety and avoid those schemes that chase higher returns by taking higher credit risk.
As an investor, these are a few crucial questions to look into to ensure that your money is parked in a Liquid Fund:
- Is the quality of the securities held in the portfolio reliable?
- What if the rating assigned to a particular debt paper slips; does the fund house have adequate risk management measures in place in such a case?
- Is the fund manager compromising on the ‘liquidity’ aspects?
To conclude…
You would be better off investing in a Liquid Fund that invests predominantly in Government securities, Treasury Bills, and securities issued by top-rated Public Sector Undertakings (PSUs). These securities carry low credit risk and are liquid, thus helping you avoid default risk.
Disclaimer: The views expressed here in this Article / Video are for general information and reading purpose only and do not constitute any guidelines and recommendations on any course of action to be followed by the reader. Quantum AMC / Quantum Mutual Fund is not guaranteeing / offering / communicating any indicative yield on investments made in the scheme(s). The views are not meant to serve as a professional guide / investment advice / intended to be an offer or solicitation for the purchase or sale of any financial product or instrument or mutual fund units for the reader. The Article / Video has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. Whilst no action has been solicited based upon the information provided herein, due care has been taken to ensure that the facts are accurate and views given are fair and reasonable as on date. Readers of the Article / Video should rely on information/data arising out of their own investigations and advised to seek independent professional advice and arrive at an informed decision before making any investments. None of the Quantum Advisors, Quantum AMC, Quantum Trustee or Quantum Mutual Fund, their Affiliates or Representative shall be liable for any direct, indirect, special, incidental, consequential, punitive or exemplary losses or damages including lost profits arising in any way on account of any action taken basis the data / information / views provided in the Article / video.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.