Amid uncertain economic conditions, wherein the recovery in global growth entirely depends upon the intensity, spread and how long the Coronavirus or COVID-19 outbreak continues, the RBI in an exceptional move took all necessary measures. In fact, it has pulled out all weapons to combat the impact of the coronavirus lockdown.

In the 7th bi-monthly monetary policy statement, 2019-20, the six-member Monetary Policy Committee (MPC) resolved:

  • Reducing the repo policy rate by 75 basis point or bps to 4.40% from 5.15% with immediate effect (an aggressive rate cut)
  • The marginal standing facility (MSF) rate and the Bank Rate were reduced to 4.65% from 5.40%
  • The reverse repo rate under the LAF (Liquidity Adjustment Facility) was reduced to 4.00%
  • And the MPC also decided to continue with “accommodative stance as long as it is necessary” to revive growth and mitigate the impact of coronavirus (COVID-19) on the economy while ensuring that inflation remains within the target

All six members of the MPC voted in favour of the decision, but two members (Dr. Chetan Ghate and Dr. Pami Dua) voted in favour of 50 bps reduction instead of 75 bps as voted by the rest.

Besides that, measures were taken to ensure that liquidity conditions in the system remain comfortable and COVID-19 related liquidity constraints are eased. The Cash Reserve Ratio (CRR) of all banks was reduced to 3.00% from 4.00% (expected to release primary liquidity of Rs 1.37 lakh crore), plus the minimum daily CRR balance maintenance requirement was reduced from 90% to 80%.

Systematic liquidity surplus under LAF stood at Rs 2.86 lakh crore in March (upto March 25, 2020). The RBI actively managed the liquidity conditions via ‘operation twist’, long-term repo auctions, and Open Market Operations.

These decisions were taken in consonance with the objective of achieving the medium-term target for consumer price index (CPI) – also known retail inflation — at 4.00% with the flexibility to go +/- 2%. 

In February 2020, India recorded the retail inflation of 6.6% which was 100 bps lower than that recorded in January 2020. The 7th bi-monthly monetary policy mentions that CPI inflation excluding food and fuel eased in February under the weight of softer prices of transport and communication, and personal care. Households’ inflation expectations a year ahead softened by 20 bps in the March 2020 round of the Reserve Bank’s survey.

The RBI is of the view that retail inflation has peaked in January, and it is expected to soften in the coming months owing to falling energy prices in the international market and shocks to demand due to COVID-19 may weaken them going forward.

Path to inflation, GDP growth and interest rates…

Going forward, according to the RBI, food prices may soften even further under the beneficial effects of the record food grains and horticulture production, at least till the onset of the usual summer uptick.

Furthermore, the fall in crude should work towards easing both fuel and core inflation pressures, depending on the level of the pass-through to retail prices. Aggregate demand would also weaken as a consequence of COVID-19 which, in turn, will reduce core inflation. That said, the central bank, observes that heightened volatility in the financial market could have a bearing on inflation.

Speaking of the GDP growth, the RBI states that the previous estimates of 4.7% GDP growth in Q4FY20 and the full-year FY20 estimates of 5% have a downside risk arising from the COVID-19 pandemic. The virus outbreak has affected the Private Final Consumption and Gross Fixed Capital Formation severely.

How this rate cut will affect debt fund investors?

As you would know, bond prices share an inverse relationship with bond yields and interest rates. Hence, RBI’s rate cut is likely to pull down yields and bonds are likely to do reasonably well. Currently, the 10-yr G-sec yield is around 6.15%.

This rate cut is an exceptional measure taken to deal with COVID-19 pandemic-led slowdown. Although inflation is expected to cool off, it is still 260 bps above RBI’s original target. As the present lockdown is also affecting production at manufacturing units, the supply-side shocks cannot be ruled out if the 21 days lockdown extends for any reason.

MPC’s commentary is crucial; it says: “The MPC is of the view that macroeconomic risks, both on the demand and supply sides, brought on by the pandemic could be severe. The need of the hour is to do whatever is necessary to shield the domestic economy from the pandemic.”

That said, overall it appears that the present interest rate cycle has bottomed out. Most of the rally at the longer end of the yield curve has already come about since the time RBI started reducing policy rates.

Which debt funds you might consider at this point?

Taking into account policy repo rates could move either way — given the “accommodative stance as long as it is necessary” — is maintained by RBI; allocating a small portion of the debt portfolio to a Dynamic Bond Fund may be considered, provided you are willing to take some extra risk. A Dynamic Fund holds the mandate to invest across maturity debt papers. The fund manager assesses where interest rates are headed to build the portfolio across the yield curve.

On the other hand, if investors are unwilling to take extra risk, then they would be better off deploying their hard-earned money in shorter duration debt mutual funds. But ensure that even short-term debt funds are approached with eyes wide open — paying attention to the portfolio characteristics and quality of the scheme. A fact is, many debt mutual funds across maturity profiles are grappling with downgraded and toxic debt papers which heightens the investment risk.  Also, given that yields have already plunged to a multi-year low, the possibility of credit risk increasing cannot be dismissed. Plus, the lockdown is likely to amplify the credit risk (owing to a slowdown in business).

So, when choosing debt funds, prefer the safety of principal over returns. Stick to debt mutual funds where the fund manager does not chase returns by taking higher credit risk. Further, assess your risk appetite and investment time horizon while investing in debt funds.

Remember, investing in debt funds is not risk-free.

If you prefer to keep your capital safe, prefer fixed deposits.

Happy Investing!

by PersonalFN Content & Research Team

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