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Debt fund returns to go down in medium-term

After one-time capital gains, returns are likely to drift lower as bond prices stabilise. Expect a 7-8% return for one-year, say bond fund managers

Its what the bond doctor ordered! After a tumultuous September that rocked the boat for most debt funds, Monday's rate cuts have spurred the net asset values for the bond category as investors' scamper to earn some quick returns. While medium-term debt funds are up an average 0.42 per cent, the aggressive gilt funds are a scorcher with a gain of 0.72 per cent. Debt funds have lagged by a wider margin since they had liquidated a large chunk of their G-Sec portfolio to facilitate redemption in September. The rally in bond markets is expected to continue for some more time and thus, give a fillip to NAVs.

The top debt funds on Monday included PNB Debt (0.70%), Templeton India Income (0.66%) and Magnum Income (0.64%). The top gilt funds for the day were Templeton IGSF (1.19%), Tata GSF (1.18%) and Prudential ICICI Gilt Investment (1.18%). And after a redemption of Rs 3,000 crore in September, the category could see net inflows this month. The fresh investments will help bond funds recharge liquidity with investments in gilts. Some money could also flow in corporate bonds, which are currently trading at attractive spreads (130-140 basis points), over sovereign bonds of similar maturity.

What Next?
The much-awaited rate cut has finally happened with one-time capital gains spurring NAVs for debt-oriented mutual funds. While bonds may continue to rise in the coming days, prices are expected to stabilise in the medium-term. On the other hand, fresh investments in bond funds will now flow in lower yielding instruments, thus pulling down the overall return on the portfolio. Thus, investors will do well to understand that an encore is unlikely and returns will drift lower in the coming months. "This is the end of bull-run in the debt market and there will be no more rate cuts by RBI. Going forward, investors can expect a one-year return of 7-8%," says Nilesh Shah at Templeton Mutual Fund. Adds Shailendra Jhingan at Birla Sun Life AMC, "The returns in the bond funds won't change substantially as the event has resulted in just 10-15 points downward movement in interest rates across the medium and long end of the corporate yield curve. Going forward, the return expectation of 8-8.25% is intact." Anyway, given a deteriorating economy, bond funds are likely to focus their investments on AAA corporate bonds and gilts, which offer low coupon income.

The RBI has also expressed its inability to lower interest rates in isolation unless the government also brings down administered rates on small savings. Thus, it seems that the RBI is now done with its bit in pulling down interest rates and another rate cut is unlikely. "Unless small saving rates are reduced, we may not see a sustained drop in the interest rates. However, it would be very difficult to drop small savings rate suddenly, as there continues to be huge maturity mismatch between the deposit liabilities of the postal savings and the deployments of these funds," points out Sandesh Kirkire at Kotak Mahindra Mutual Fund.

Fund managers concur that interest rate environment is expected to be stable in the medium-term with the yield on the 10-year benchmark moving in a cordon of 30-50 basis points (8.75% to 9.25%). Despite a surfeit of liquidity, the RBI may not allow a dramatic fall in interest rates and cap any rally with auctions and OMO sales. On the other hand, a sharp pickup in yields is also ruled out since it hampers recovery in the economy. "We are now in a period of stable interest rates. The yield on 10 year paper will move in the range of 8.75 % to 9.00 %,'' points out Shah. Seconds Ramgopal Kundurthi at IL&FS AMC, "I see interest rates stable to lower with a medium term target of 8.75% on 10 year gilt."

Risks Galore
While bulls may be out in strength on the Bond Street, the markets are still highly susceptible to event risks. Apart from the war in Afghanistan, a large fiscal deficit and sudden credit pickup along with government borrowing could put prices under pressure. "Apart from external risks in the short-term, fiscal deficit represents the biggest risk for bonds and any major reversal would be prompted by "pricing in" of this consideration by the markets. Also, a lot depends on how fiscal responsibility bill is operationalised," elaborates Kundurthi. Then, the rupee could also play a spoilsport. "Any pressure on rupee in the last quarter due to pick up in demand could skew the trade balance as imports will pick up and exports will continue to de-grow in an environment of global slowdown," adds Jhingan.

The Right Step
Do not go by past returns from bond funds or else, you may end up being disappointed. While the current year has been exceptional, bond prices are now expected to be range-bound. Hence, aim for a reasonable return (i.e. 7-9% per year). If you expect superlative returns, you end up investing against your basic risk profile. This, in turn, means losses. The investment horizon is also important. Do not invest your short-term balances in bond or gilt funds just on the back of a rate cut.

With cut in bank rate, banks are likely to reduce their deposit and lending rates. This would probably add to the attractiveness of bond funds, which combine higher returns with easy liquidity and transparency. However, do not let past and greed guide your investment decisions!