Interest Rate Advantage

The RBI’s sharp interest rate hike has raised some questions about its impact on fixed income mutual funds. While there is no doubt been an impact, it’s more in the nature of the confirmation and cementing of an existing situation rather than anything new. Certainly, whenever interest rates rise, there is an impact on the price of debt securities and thus there should be a fall in the NAVs of funds that are holding these securities. Currently, rates have been on their way up steadily since February 2010, and no one can realistically say, with any certainty when and where this trend will halt or reverse. The finance minister himself has said that this may not be the last hike.

However, this impact of rate hikes is proportional to the residual maturity of the securities. For securities that are maturing within a few weeks or months, this impact is minimal. And as it happens, the fixed income mutual fund market has moved decisively away from long-maturity securities a long time ago. While the magnitude of the RBI’s rate hike may have been a bit of a surprise, its general direction was exactly as expected and was part of a long-established trend. For over two years now, investor money has been moving out of the longer-maturity mutual funds, and these funds have themselves been shortening their maturity for whatever money remains in them.

This trend actually dates back to before the current trend of rate hikes. In general, the structure of the fixed income debt fund market has changed. Investors are less inclined to try and ride interest rate movements. In an environment where rates primarily go up and may start receding only at some point in the future, there is simply no sense in investing in funds that may invest in long-maturity securities. Fixed income investors are very safety-oriented and any prospect of loss is quite a serious matter.

So if longer-term funds are out, then where has the smart investor money gone now? The answer depends on how much liquidity they need. If the money needs to be on call, then it has to be in an open-end fund and that means short maturity funds. However, if you are ok with the money being locked away for a longer period of time—like a year—then Fixed Maturity Plans (FMPs) are a great option. FMPs are closed-end funds so the fund manager is not constrained by the market price of securities or anything like a rate change. The investor’s yield is determined solely by the coupon—interim NAV movements during the fund’s tenure are irrelevant. For the investor, this basically makes these funds a deposit. It is true that unlike a deposit, investors don’t have a clear promise of what the returns will be, but in practice, all FMP investors have a good idea of what they are going to make.

Currently, investors can expect about 9.7 per cent of returns from one year FMPs that have started in recent weeks. About a year back, this number was about 8.25 per cent. Going forward, even higher returns can be expected. And if you take the dividend plan, then the returns are obtained in a more tax-efficient manner than equivalent bank deposits. All in all, this makes FMPs the one class of mutual funds that will not only not be harmed by the rate hike, but will actually benefit out of it.

However, all things said and done, debt funds in India are used almost purely by corporates. Even though they offer some returns and tax advantages over bank deposits, individual investors don’t perceive the advantage to be worth it at the scale they invest. For a business which is investing crores or tens of crores and has finance professionals on board, the differential is big enough.