How You Should Position You Debt Portfolio Post Demonetisation…

The fortnight after the demonetisation declaration, banks are being flushed with large amounts of cash. The Jan Dhan accounts saw a 60% increase and a record high on deposits ever since its inception.

There is a large amount of cash available with banks now, but there isn’t enough demand for credit from the corporates. And the demand is likely to remain muted for the next few months as well.

Further, interest rates are expected to fall and many banks have lowered the rate of interest on deposits already.

To deal with the excess liquidity available in the banking system, the Reserve Bank of India (RBI) announced, all the incremental deposits accounted between September 16 and November 11 should be deposited with the regulator as part of the mandatory ‘incremental Cash Reserve Ratio’ (CRR) of 100%. This is a temporary measure to control liquidity until other Market Stabilisation Bonds (MSS) and open market instruments are introduced.

Besides, the Government has also issued market stabilisation bonds to suck out excess liquidity from banks. As soon as these are issued to the market, the RBI may roll back the diktat of maintaining ‘incremental CRR’.

So, banks are back to square one — from comfortable liquidity to a liquidity crunch. Nonetheless, thankfully RBI has provided some relief by conducting variable repo operations worth Rs 3.30 lakh crore — which would help them to tide over cash requirements.

However there have been repercussions….

On one hand, a potential policy rate cut by RBI has is making long duration debt funds tempting while on the other, liquid funds are observing huge cash outflows.

With ample of cash lying idle in banks (but more in denomination that are no longer circulation) and fewer opportunities available to allocate this liquid cash; and in such circumstances, most of the times banks resort to Government securities. As a consequence, the benchmark yields start declining; leading to surge in bond prices (testifying the inverse relationship). The yield of 10-Yr 7.59% G-sec 2026 has declined to 6.25% as on November 30, 2016 from 6.79% on November 8, 2016.

How should you position your debt portfolio?

Long-term debt funds

The expectations of the RBI cutting policy rates at the fifth bi-monthly monetary policy review scheduled on December 7, 2016 has made many investors go bullish on bond funds. In the falling interest scenario, bond prices of long-dated bonds move upwards resulting in capital appreciation for its investors.

In the current scenario, the demand for gilt funds, dynamic bond funds, and income funds has increased.

But hold your horses and avoid going gung-ho while taking exposure to long-term debt funds.

Most of the rally has already been captured at the longer end of the yield, and further steam seems to have reduced. Yet in case, if you’re willing to take risk, want play aggressive, and have an investment horizon of at least 3 years; you may consider allocating not more than 20% of your entire debt portfolio to long-term debt funds. But when you do so, consider dynamic bond funds. They have flexibility enabled by their investment mandate to invest in long and short maturity debt papers, depending on the current market outlook.

The interest rates in India are likely to ease in the coming future. But don’t merely speculate on interest rate movement. It’s pointless, dangerous, and unhealthy in uncertain times.

Liquid Funds and Ultra Short-term Funds

Liquid Funds have seen the highest number of withdrawals in the last fortnight. The ‘incremental CRR’ of 100% on increased Net Demand and time Liabilities (NDTL) has resulted in heightened redemption pressure on liquid funds. Banks are being forced to liquidate their investments to meet the cash requirements.

But given an uncertain scenario, where there’s a potential risk to GDP growth, allocating a dominant portion of the debt portfolio to liquid funds would be a relatively safe investment proposition if you have an investment horizon of less than 3 months.

If you have an investment horizon of 3 to 6 months, consider investing in ultra-short term funds (also known as liquid plus funds). They too can be an appropriate.

While you invest in debt mutual funds, remember they aren’t risk-free. There’s some element of risk involved due to economic factors, including interest rates. So, you need to clearly gauge your risk profile and investment horizon, to smartly position your investment portfolio.