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Will The Gains Last?

With a one-year return of 13.3%, bond funds have comprehensively beaten their fixed-income counterparts. But, are these gains sustainable? Read on to know more.........

You are wondering why the one-year return on your bond fund is a whopping 13.3% when your provident fund yields only 9.5%. Well, that's because the current calendar has been Manna from Heaven for bond markets. With the dream run on, investors have poured crores into bond funds. Yet, like all good things that come to an end, the current spell of humongous returns cannot be sustained. "Its too good to be true,'' quips a fund manager. The yields on underlying securities, which move inversely to bond prices, have already reached a historical low. For instance, the 10-year sovereign bond has seen its yield drop from 11.5% in July 2000 to current levels of 10.35%.

Apart from event risks like a weakening rupee or an oil price hike, marketmen believe that the rally in bond prices could start to slowdown as investors refrain from putting fresh money at higher levels. "We are bound to see some sort of correction in the near term but any correction will only be seen as a buy opportunity by the market," says Rajiv Anand at Standard Chartered Mutual Fund.

But First, What's Driving the Bull-Run?
The incessant climb by bonds has been facilitated by a slew of rate cuts this year. Apart from two bank rate cuts of 50 basis points each to spur a slowing economy, bond markets were bestowed with a couple of reductions in cash reserve ratio or CRR that infused fresh money in the system. With the economy failing to look up, the markets have been expecting another rate cut for quite some time now and thus, driving up bond prices. Further, the deposit base of banks has grown at a rapid pace, which have been chasing bonds in the absence of alternative deployment avenues. For instance, in a slack economy, there is little demand for credit from companies. "The aggressive buying by banks is leading to the rise in the bond prices and hence a reduction in interest rates. It is really a million-dollar question as to how long this would continue,'' says Sandesh Kirkire at Kotak Mahindra AMC.

Going Forward
As rally starts to slacken and yields consolidate at current levels, a slower price appreciation and locking investments at lower yields (or higher prices) will pull down total return. Bond market players are now uncomfortable with current price levels. "Majority of the funds have been indicating returns in the region of 8-9% going forward,'' says Shailendra Jhingan at Birla Sunlife AMC. Thus, the returns from bond funds are expected to fall in line with yields on comparable instruments.

Re-aligning to the emerging trend, fund managers are also cautiously bullish for the medium-term. Thus, even as most bond funds have reduced portfolio maturity in June, they are still in the aggressive zone with the average life of a bond at four years. "The average maturity for Birla Income Plus that was 5.2 years in May end was brought down to 4.6 and would now be at 4.4 years,'' says Jhingan. There is a direct relationship between portfolio maturity and interest rates with a longer-dated portfolio more sensitive to interest rate changes. For instance, a fund with a portfolio maturity of five years will gain more than a fund with a maturity of 3 years when interest rates go down.

Investment Strategy
While the current returns are tempting, investors should not be lured into investing in bond funds in hope of making super normal gains. There is already some uncertainty in the markets since the much-wanted bank rate has failed to take place. While banks are currently investing heavily in government bonds, any pick up in credit demand from companies post-monsoon could force them to liquidate and trigger a selling pressure. The party could also end if the RBI feels that yields have fallen to uncomfortable levels.

Thus, invest in bond funds with a longer-term perspective and rein in your expectation. While bond funds have been sizzling this summer and beaten equity funds hollow, the returns could turn placid now. Add to it, any shocks in the near future are bound to spoil your returns and leave you disappointed. So, enjoy the hefty gains as long as they come but tone down your expectation!