What's behind the Debt Market?

By Raghav Taparia

India’s GDP recorded its steepest quarterly plunge, contracting by 23.9% in Q1 of FY2021 as the Covid-19 lockdown hit almost all the sectors from Manufacturing to Service and Construction. With RBI’s Liquidity support of over Rs.1 Lakh Crores and continuous cutting down of the Interest rates, Indian stock market has rebounded quite well despite weak economic activities and demands reviving slowly. Mutual Funds also saw a big fall in their NAVs and the SIP contributions also dropped from 8641cr. in March to 7900cr. in June 20. The Benchmark indices have almost returned to their pre-lockdown levels too. This unprecedented liquidity effect from RBI may have led to a rally in Equities which are gradually bringing the Equity MFs on track, but this effect is not dripping down to the Loans and Debt Market, making the Debt Market the new Red-Zone area of Investments.

The first thing that comes to investor’s mind when they think of Negative Debt returns is their experience with Franklin Templeton who was unable to recover the money which was lent in the market and eventually had to close down 6 Debt Funds. This is a Credit Risk or Default Risk which prevails in all types of markets. But, in these situations of Pandemic, the Debt Funds are facing Interest Rate Risks which occur mainly due to the fluctuations in the interest rates by the Central Bank. To understand why Interest rate set by the RBI plays a key role in the Debt market, let us understand the major investment avenue of the Debt Mutual Fund Houses which is Bonds.

Most of the Debt funds make a minimum of 50-60% of the total portfolio in Bonds of different varieties. Bond yields are majorly affected by the Monetary Policy and these policies at their core are about determining the interest rates (Risk free rate of return) which affects the demand for Financial Securities including Bonds.

 

How do Bond Prices Fluctuate?


Example: Say a 10 yr Govt. Bond of Rs.1000 is trading at an annual coupon of 6.6% p.a and RBI in its monetary policy slashes the policy rates from 6.5% to 6% p.a.  Now, as Bonds are giving more returns than the Risk free rate so, the demand of the Bonds is going to increase and eventually the price of the bond will increase from Rs.1000 to Rs.1060.  So, here two main rules of Bond Markets can be identified which are:

1. There is an Inverse Relationship between Interest Rates and Bond Prices. When RBI reduces the Interest rates, the demand for Bonds increases and eventually price of the bond increases and vice versa.

2. Increased Demand for Bonds leads to Rise in the price of the Bonds in the Market, which at some point of trading will result in Falling Yields from the Bond (as the annualized return reduces from the Bonds.) and vice versa.

So, when the threat of virus spread rapidly, investors fled from Equities and other riskier assets and invested in bonds as they considered it to be safe at that time, which made the Bonds price to rally up with increased demands. RBI’s rate cut and liquidity operations also gave a boost in that rally which eventually led to the yields on 10yr Govt. Debt to fall to 5.74% p.a by July end, which rallied to 6.5% p.a in April as the demand was continuously increasing and gradually yields from the bonds came down. Finally, now some relief has come in the Bonds Market when in August the RBI announced to not to cut the policy rates more as inflation rates are hovering at around 6% in this month which led to Bonds yields to also come back to 6% p.an again.

But still the problems are not yet solved. Bond Market is expected to be more volatile as Foreign Investors are backing off from the Debt Market continuously since the last 3 months. One positive thing that has been noticed in this crisis is that earlier people used to believe that debt funds are very safe with minimal risks and they were chosen as an alternative without understanding the markets and the risk factors involved and this has been a case since 2018, where the Debt market has not performed well till now, but now they came to know the various risk factors involved in it and people can now take a more precise decision regarding their investments here according to the risk factors of their Portfolio.

According to the current situation, in the near short to medium term Debt Funds are expected to be volatile and can give soft returns. For short to medium term Multi-cap Funds can be considered as an option to invest in after the SEBI guidelines announced in the first week of September.