The bond market has been highly unstable lately. A series of interest rate cuts and then rising bond yields have already caused a high level of volatility in the returns offered by long duration debt funds in the last one year. Long-term debt schemes, in the last one year, have offered returns ranging from double-digit to negative. Fund managers fear that the increasing threat of inflation in domestic as well as the global markets, may further dampen the performance of these funds. They prefer to hold higher cash positions in their schemes to hedge the risk as a comfort to the investors.
"We had for now increased cash levels to approximately 45-50 per cent in our actively-managed bond and gilt funds as at June 21, 2021. Recent events (concerns around inflation) have emphasised to us the importance of this flexibility and the need to have it in amounts that can significantly buffer us against market volatility," says Suyash Choudhary, Head of Fixed Income, IDFC Mutual Fund. The calls may change at any time based on our evolving assessment, he adds. The AMC has been raising the level of cash in its actively managed bond portfolios for sometime. As on June 14, 2021, these schemes had cash levels between 20-35 per cent.
Latest consumer price inflation (CPI) reading for the month of May 2021 stood at 6.3 per cent, clearly breaching the RBI's upper threshold limit of 6 per cent. In FY 2020-21, CPI breached the RBI's upper threshold and averaged at 6.2 per cent. Since that was a year of big economic shock, the RBI ignored the inflation and kept monetary policy extremely accommodative to revive growth. This was also based on a hope that the inflation is transitory and will come down over the period.
"Evidently, inflationary pressures have sustained," says Pankaj Pathak - Fund Manager - Fixed Income, Quantum Mutual Fund. According to Pathak, retail inflation has a history of being sticky. It usually creates a feedback loop and feeds into inflationary expectations of consumers that can lead to even more inflation. Household inflation expectation as per the RBI's survey has already started moving higher.
The RBI targets to keep the headline CPI Inflation at 4 per cent with a broader range of 2-6 per cent. However, the CPI has been running consistently above the RBI's goal of 4 per cent for the last 20 months.
Rising inflation is not limited to India, it has become a global concern. CPI inflation in the US rose to 5 per cent in May 2021, highest in 13 years. Other advanced economies are witnessing pick-up in inflation as well.
Why is inflation a concern for bond or debt mutual funds? Well, rising inflation pushes interest rates higher and prices, in turn the Net Asset Value (NAV) of long term bonds, lower.
What will be the RBI's next move?
Debt fund managers believe the CPI inflation may sustain above 6 per cent threshold for some time. "The RBI, in its policy thinking, has been running a risk of mis-judging the inflation threat. Thus, persistent inflation could prompt a change in policy thinking sooner than anticipated. May CPI numbers could very well become an inflection point in the RBIs monetary policy cycle," says Pankaj Pathak.
The RBI, says Suyash Choudhary, will probably fall back into 'orderly evolution of the yield curve' mode signifying more tolerance for marginally tighter financial conditions than what exist currently. "Over a longer period of time, it is possible that there is a further reduction in its intensity of bond interventions again consistent with its view on financial conditions then," he says.
Lesser RBI intervention could push bond yields higher.
Pathak sees policy normalisation to start in the second half of FY22. "The RBI could change its policy statement in the August review to incorporate inflation risks appropriately in its forward guidance. However, any policy action seems unlikely at this moment," he added.
Since January 2020, the RBI has cut the policy repo rate by 115 bps and the reverse repo rate by 155 basis.
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