The RBI for the first time since the formation of MPC committee in October 2016 has brought about a back to back rate cut after February's 25 basis points repo rate cut. And after this fiscal year's repo rate cut effected last week by again 25 basis point repo rate i.e. the rate at which RBI lends money to commercial banks stands at 6%. While this key rate has been in a narrow range, interest on deposits, lending rate as well as bond yield has for quite some time remained in a broad range.
This is primarily because rate transmission is not in line and it is what RBI and MPC should focus on. And what is required is liquidity push such that market interest rates and lending rates may move lower to reflect the lowering in the key repo rate.
For the move, RBI has been strengthening liquidity position of the economy through open market operations (OMOs) as well as foreign currency swap i.e. exchanging dollar reserves with the rupee currency to fully re-monetise the economy which has been witness to demonetisation in the year 2016.
Also, the RBI has maintained a neutral stance in its monetary policy review, meaning overseeing the economic changes from time to time may resort to hiking rates.
Bond Markets And Repo Rate Cut
As such bond markets already discounted a 25 basis points rate cut and further rate cut given the inflation situation and bond yields that share an inverse relationship with bond prices have reversed the gains posted during the last week. And at 6% repo rate, the 10-year government bond yield at 7.25% - 7.35% is fairly valued.
But as the picture in the wake of elections and the prospect of a future rate cut, likely lower OMO purchases, the bond yield is likely to remain higher in contrast to what should be the case considering the economic situation and monetary policy stance.
Also, issues concerning oil prices, which today have again touched 5-month high given the Libya clashes which make bond yield highly volatile. And the move is likely to hinder the transmission of rates on to the broader economy.
So, given the volatility in bond markets, the following can be returns and hence likely reaction of different bond market investors:
Liquid Funds Or Low Duration Bonds:
As liquidity is infused into the system and because of the rate cut, yields or accrual on the short term debt instruments fall and hence investors are most likely to get lower returns.
Liquid funds are suitable for investors when they have a short term surplus and these funds come in handy to meet short term goals such as payment of insurance premium or child's tuition fee which become due at a monthly or quarterly basis.
Fixed Maturity Plans Or Short Term Funds:
The repo rate cut will not reflect on the interest rates on FDs as well as short term funds until the RBI takes further action for better transmission of rates. The rates on such debt instruments are largely to remain range-bound.
Long Term Bond Funds:
Also, given the uncertain macro economic outlook, investors need to price in these aspects and consider the short term volatility in the bond markets to only invest with a 2-3 year time line.
Dynamic Bond Funds:
This bond segment can prove to be a better choice as it allows the fund manager to change allocation as the economic situation pans out.
Also, one cannot ignore the credit risk and liquidity risks these bond funds are prone to after the IL&FS crisis that hit the Indian economy hard in September 2018.