Despite a marketwide unanimity that the Reserve Bank of India (RBI) in its policy review meeting of September 4 will maintain a status quo on key policy rates — the repo and reverse repo rates that determine the rate of interest in the economy — the central bank under a new governor raised rates. RBI also shifted its focus from targeting wholesale inflation (measured by wholesale price index, or WPI) to retail inflation (measured by consumer price index, or CPI). The twin moves led to a rise in the rate of interest in the economy, fall in bond prices and hardening of yields (bond prices and their yields are inversely related). What is worse is that since RBI is targeting CPI rather than WPI, which was the norm earlier, there is rising expectation that it will raise rates again in its monetary policy review meeting later this month.

For investors who are relatively risk-averse and invest in debt instruments (also called fixed income instruments), this is a moment of uncertainty. This stems from the fact that when there is a chance of rate of interest going up, yields rise and bond prices dip, leading to losses in the portfolio of bond investors. Since mutual fund schemes hold various fixed income instruments in debt funds, the fall in bond prices also pulls down their net asset values (NAVs), leading to losses for investors in those schemes. So the question for debt fund investors is how they should behave in such times.

According to financial advisors and planners, mutual fund investors, whether investing in debt or equity, should always have a long-term approach, which is 5, 10, 15 years or more. So they should not panic or jump to rejig their portfolio just because there is come uncertainty about the rate of interest in the economy at present. Investors should not rush in to take advantage of the interest rate volatility. In other words, investors should not try to time the market and play the rate of interest game.

They should plan for the long term and invest in instruments which give about 8-9% return annually. This is because for long-term debt investors, the intervening rate volatility does not matter much. What matters more is the credit risk they would carry in their portfolio while investing for the long term. Credit risk is a dynamic factor and any risk of downgrade of the debt instruments should be kept in mind while investing for the long term.

The credit risk in a debt instrument is important because in the bond market, if a bond is downgraded then the price of that bond falls because less number of people want to hold that instrument in their portfolio. The reverse is also true: An upgrade in credit rating leads to a rise in prices of that bond. So it's important to invest in the fixed income instrument of companies with history of stability, a long history and also a track record of stable cash flows. There are quite a few companies which meet all the three criteria and debt investors, who prefer to invest directly, should look at such companies.

A recent research by HDFC Securities pointed out that generally, the prices of the lower rated debt instruments fall the most during periods of high uncertainty over direction of interest rate movements in an economy in comparison to the highest rated debt instruments. Consequently, mutual fund schemes which have allocated most to these securities see depreciation in their NAVs and end up with lower or negative returns.
However, the report also pointed out that in the last two years, interestingly, debt mutual fund schemes that have invested maximum of assets in "AA & below" rated debt securities outperformed the schemes that hold maximum in "AAA/A1" rated debt securities in the last two years. AAA-rated bonds are the highest rated debt instruments which carry lowest amount of risks while anything rated below has higher risks of investment.

Financial planners also say that if a debt investor invests for the short term, say for a year or two, then he/she will have to carry large price risk as well as re-investment risk with portfolio. Price risk means if there is a downgrade or a rise in the rate of interest in the economy, the price of the debt instrument will fall, leading to a loss in the portfolio. Re-investment risk is the risk of getting a lower rate of interest when the debt instrument in which the investor is currently invested matures and the money received at maturity has to be invested in other debt instruments that pay rates lower rate. For example, some of the better debt mutual fund schemes are poised to give about 9-9.75% return for one year investments. However, if after a year the best of the ones are set to pay about 8%, the investor will have to settle for the lower rate.

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