Personal Finance

Can debt funds beat inflation?


One of the main objectives of saving for the future is to create a corpus for retirement when one is no longer working and having a steady cash flow. A usual rule of thumb to follow is to ensure that the return on investments while choosing investment products should be higher than the inflation that is expected from the present period to retirement and beyond. Thus, if we are to maintain the same consumption pattern as we do currently or the same standard of living, we need to ensure our cash flows in the future (our savings) are enough to cover for same after accounting for inflation.

While it’s prudent to follow a balanced asset allocation among various asset classes like Equity, debt, gold etc and to ensure the combined portfolio return generated can beat inflation, this article will focus on debt funds. To begin with it is important to define inflation itself. Everyone’s consumption pattern can be different although we may agree broadly that certain classes will be common. For example, food items, housing/rent, electricity, fuel and transportation, medical care, education etc.

In India policymakers focus on two or three important measures of which the currently accepted main one is headline CPI (Consumer Price Inflation) which attempts to measure a representative basket of retail prices for various classes of items. There is also the Wholesale Price inflation (WPI) as well as the GDP deflator (a mix of WPI and CPI inflation). In the last five years the RBI (Reserve bank of India) has been fairly successful along with the government in containing inflation. CPI inflation has averaged 4.50% for the five year period from April 2016 to March 2021.

In the next coming five years too RBI will focus on the headline CPI as the main metric of inflation for policy decisions. Now if we compare this with returns given by actively-managed debt funds, it would seem that debt funds have managed to beat inflation as a category. Consider gilt funds which as a median fund category delivered around 8.00% plus for 5 yr period (as on 21st April 2021).** If one looks at another main category of debt funds, the Short Duration Debt Category then median fund category returns have been in range of 6.5% for same period**.

In recent times due to continuous rate cuts by RBI in the last two years and abundant banking system liquidity, we have seen short term rates fall sharply. RBI’s Reverse Repo rate is at 3.35% and 3 month T-bill rates are trading around 3.35% as well. 1 yr T bill rates are trading around 3.75%. So, there are concerns among investors who are looking to make fresh allocations to debt funds if their returns can outperform inflation?

I would highlight three main points to consider

  1. While it’s true that very short-end rates are trading at levels around 4% or lower there is still value to consider when one looks at 3 to 10 yr segment across corporate bonds, SDLs and government securities. Hence balancing the duration of debt and remaining invested for longer periods of time (ideally 3 years and above) can still help to deliver decent returns.
  2. Relook at asset allocation and rotate to asset classes with higher expectations of returns while keeping risk appetite in mind.
  3. While this year RBI will likely prioritize growth, however focus on inflation would come back in case there are further inflationary pressures. Else market rates may adjust higher.

Finally, if this sounds complicated, do consider taking the help of a reputed registered investment advisor to help you navigate in these volatile times.

(The writer is Head- Fixed Income, Principal Asset Management.)



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