The high interest rates in the short-term debt market have been the focus of investor attention in the recent past. The traditional bank depositors are being lured by the spiked rates, making most other bonds unattractive, while the wholesale deposits are being offered on even more attractive terms, leading to a slew of fixed maturity plans (FMPs). Based on the assumption that such steep rates may not persist, a tactical investment opportunity may be present in the short-term debt markets.
What has led to this spike in interest rates? There are three primary reasons. First, the high inflation rate has sparked a hike in policy rates by the Reserve Bank of India. The rate at which the central bank is currently willing to lend to banks is 6.75%, as opposed to 3.25% a little over a year ago. This was the time when banks were primarily lending to the RBI at that rate as there was a slowdown in the demand for loans.
The second reason is that while the demand for bank loans has moved up sharply, the growth in deposits has not kept pace. Investors have mostly held currency in hand since the rates offered by banks had been too low for too long. Third, there have been frictional pressures on short-term rates, especially due to the high level of unspent current account balances of the government that are held with the RBI.
The current market view is that there will be a correction in interest rates after the seasonal demand (at the end of March) comes down. Investors want to look beyond the FMP in a rising interest rate market, when a new plan offers a higher rate than the older one. Locking into high-rate, fixed-tenure instruments requires a strategic call to stay invested for the long term. Those who have chosen to buy high interest deposits and FMPs have decided to stay invested till maturity and may not care about the various changes in interest rates in the interim.
The investors who want to play the short-term debt market are being plagued by two questions: Is a correction likely in the short-term rates? If yes, which product will help capture this gain the most? The gains that investors make from short-term debt funds can come from two sources-interest income and capital gains from a fall in market interest rates. If the rates have gone up by 3-4% in the past six months, they are unlikely to fall to the same extent. This is because a majority of this increase was due to the rise in policy rates by the RBI, and given the inflation levels, the central bank is unlikely to let the interest rates fall. The government's balance with the RBI has already returned to normal levels. The only correction then is likely to be in bank deposit rates, provided the banks have managed to mobilise the volume of deposits that they had planned through aggressive pricing. The correction in deposit rates is likely to be about 1%, or even less.
For a tactical play on this possible turn in rates, an open-ended, short-term plan could be a good bet. However, two caveats are in order. First, the gain from falling rates in short-term debt funds could be small. This is because they all offer very low average tenures to capitalise on the rising interest rates by re-investing in instruments that are rated higher. The low tenure, along with low rate change, results in low gains.
Second, reduced rates will mean lower interest income in the future, so the overall return may be lesser than that being currently offered by these funds. The funds that have enhanced their tenures in anticipation of a drop in rates may be under-performing their peers, but if the prediction about the short-term interest rate plays out as expected, they may gain the most. Tactical rebalancing is about taking a risk by positioning your portfolio based on a particular view, rather than waiting for performance numbers to play out.
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