How operation twist will affect debt mutual fund investors

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On 19 December, the Reserve Bank of India (RBI) announced an unusual set of operations—that it was selling government bonds maturing in 2020 and buying those maturing in 2029. RBI repeated this action on 26 December, to be conducted on 30 December. RBI’s initial action, now popularly called Operation Twist, was seen as the Indian version of an action undertaken by the US Federal Reserve in 2011 as part of its efforts to revive the economy hit by the global financial crisis.

Though the amount involved in Operation Twist— 10,000 crore each in the two actions—is modest, many market participants feel such actions can have major implications for the debt markets and interest rates. This can, in turn, affect debt mutual funds because their returns increase when interest rates fall and vice-versa.

What to expect

Operation Twist involves the buying of long-dated bonds and selling of short-dated ones by RBI. This will do two things, said experts.

“It will lower the term premium and will benefit investors in longer maturity funds,” said Dwijendra Srivastava, head, fixed income, Sundaram Mutual Fund. The term premium is the extra yield that bonds with a longer maturity pay out. This is because investors see longer-dated bonds as riskier and demand higher yields for holding them. For example, a three-year bond yield is around 6.5% but a 10-year bond yield is close to 7.5%. Operation Twist aims to reduce this spread, bringing down the cost of long-term borrowing.

“Operation Twist attempts to get yields of long-term bonds lower without any rate cuts,” said Arvind Chari, head, fixed income and alternatives, Quantum Advisors Pvt. Ltd. RBI paused the rate cut cycle in its 5 December monetary policy. Lower rates raise the prices of these bonds and hence the returns of debt funds holding the bonds. These include medium-term, long term and government securities (gilt) funds.

The extent of the sensitivity of a fund to interest rate changes is measured by the modified duration. This gives the percentage change in a debt funds’ value in relation to the percentage change in interest rates. For example, a modified duration of five means that a 1% fall in rates will cause a 5% jump in the value of the fund’s portfolio, other things being equal.

Many hybrid funds also hold long-dated bonds and their returns are affected by rate changes. “If such moves continue, bond yields may fall by up to 20 basis points,” said Srivastava. Investors in long-dated funds may benefit from a further fall in yields as a result of Operation Twist.

Over the past year, interest rates have fallen by a significant margin. The yield on the benchmark government of India bond has fallen by 7.30% to 6.60%, a drop of 0.70% (as on 24 December). This has caused a rally in long-dated funds. Gilt funds which invest in long-dated government bonds have delivered 10.12% over the past year compared to their five-year average return of 8.08%. At the same time, long-duration funds have delivered 12.12% compared to their five-year average return of 8.76%.

Within days of RBI’s announcement of Operation Twist, yields on 10-year government bonds fell from 6.75% (on 19 December) to 6.58% on 24 December. Long-duration funds, on average, rallied by 1.88% over the same period and gilt funds shot up by 1.10%. If RBI were to conduct more such operations, these categories of funds may see similar gains in the near future.

Risks to consider

Before jumping to buy long-dated debt funds, consider some risks.

First, the ongoing slowdown has hurt the government’s tax collections, putting the fiscal deficit target of 3.3% in jeopardy. The fiscal deficit is the extent to which the government’s expenditure exceeds its income. A higher fiscal deficit means that the government needs to borrow more. This, in turn, means higher interest rates in the economy, as the government competes with other borrowers. As a result, bond prices head lower and so do returns on debt funds.

Second, inflation was unexpectedly high in November 2019, rising to 5.26% from 4.62% in the previous month. RBI’s target inflation band is 4-6% implying that higher inflation may force the central bank to be more cautious on easing interest rates.

The third risk is reading more into the RBI move than is warranted. “RBI’s action has given the signal that long-term yields were too high. A kind of cap on yields has been placed. However, that does not necessarily mean that it wants to keep bringing yields down,” said Mahendra Kumar Jajoo, head, fixed income, Mirae Asset Mutual Fund. “For that, traders would want to see a few follow-ups such as buy auction on long-dated securities,” he added.

Chari said that investors can take a tactical view in investing in long bond funds. “But we don’t see this as a structural bull run in the bond markets. The best of the bond gains is behind us,” he added.

RBI’s Operation Twist holds out some relief to investors in long-dated debt funds and the National Pension System, the debt funds in which tend to hold long-maturity bonds. However, investors may not want to position themselves for similar actions in the future. The ballooning fiscal deficit poses a key risk to long-term bond yields.

Above all, investors’ asset allocation must be tailored to their risk appetite and goals. Investors with time horizons of three years or less should stick to short-duration, money-market or liquid funds, depending on their precise requirements. Tactical calls, if any, are a secondary concern and should be taken with great caution.

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