Debt Funds Returns Jump High

The demonetisation has injected adrenaline into the debt market. A large number of old `500 and ` 1,000 notes have been deposited in banks. Rough estimates say deposits have crossed the `4.5 lakh crore mark. But the outflow has not happened because of withdrawal restrictions imposed by the RBI. With abundant money already in the bag, banks have started cutting fixed deposits rates. SBI, ICICI Bank, HDFC Bank, IDBI Bank and Kotak Bank have already cut rates and others are expected to follow suit soon. Investors should rush to open fixed deposits if they wish to lock in at the prevailing rates.

Since banks are flush with funds and don't have much lending opportunity, they have started buying government securities aggressively, resulting in a sudden rise in bond prices. The benchmark 10-yield came down to 6.43% (see chart). The yield on 3-month bonds have also crashed from 6.40% on 8 November to just 5.94% now.

Long-term bonds have seen the highest price appreciation due to the drop in yields. Debt mutual funds holding long-term bonds have shot up 2.8% in the past 10 days since Prime Minister Narendra Modi made the earth shattering announcement (see table). This is what the category normally earns in 3-4 months. Some long-term gilt funds rose more than 3% absolute returns during this period. What should debt fund investors do now? Experts are advising investors not to get into liquid funds and take some accrual based duration funds. Yields are coming down and two-month commercial papers are now quoting between 6.1% and 6.3%. Large reverse repo size indicates that the pressure on yield may continue till the end of the year.

Since the 10-year yield has already came down to 6.43%, does it makes sense to invest in long-term gilt or debt funds now? The general view is that the trend will continue to go down in the short term. The yield may fall further in the short term because of the pending incremental demand and trending down in inflation. Adding fuel to the bond rally is the expected rate cuts by the RBI. Since there is a consensus in the market on this, is the rate cut already priced in? Not fully, says Iyer."Of the 50 bps cut we are expecting, it seems the market has already priced in the 25 bps cut

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