VR Logo

Turnaround in debt funds

Long-term gilt and income funds are now topping the charts, having ousted liquid funds. But why is there so much return divergence in this category?

Amidst the fireworks in the stock market, did you miss the turnaround in debt mutual funds?

Taking stock of returns for the first half of 2014, it is clear that the Modisarkar has been quite good for debt funds too. Gilt and income funds which invest in long term instruments have now climbed to the top of the debt category, clocking a 6.75 per cent gain (not annualised) in the first six months of 2014, after producing a measly 2 per cent return for 2013. Income funds averaged a 5.7 per cent gain in 2014 (they were up less than 8 per cent the whole of last year). Liquid and short terms funds which ruled the category last year with a 9 per cent return, have made a 4.3 per cent gain in the first half.

A rise in bond and gilt prices due to relentless FII purchases of g-secs, the RBI indicating a pause in rate hikes in January, hopes of fiscal consolidation and subsidy reform from the new government - the factors which have helped long term gilt and income funds make a comeback are many. Debt funds are finally begin to reward long term investors who invest in them for 3-5 years instead of delivering the best returns to those who park their 3-6 month money in liquid funds.

But having said this, not all debt fund managers have made hay while the sun shines. Just consider the return divergence between the best and the worst funds. In the gilt fund category, the bets fund clocked a 6 month gain of over 10 per cent but the worst one made only a third of this return -3.50 per cent! In Income Funds, the best was up 8.3 per cent but the bottom-of-the-pile delivered sub-3 per cent. Why this yawning gap between debt funds? After all, while equity funds have a vast array of 6000 listed stocks to choose from, but debt managers have only a limited menu of g-secs and bonds! How could they miss the rally?

Well, this seems to be due to the very different views on interest rates that fund managers seem to hold. While some managers believe that we are now at the beginning of a secular decline in interest rates (which is bullish for long-term bonds), others prefer to be cautious after the wrong rate calls of 2013. According to the first camp, FII purchases of Indian bonds, fiscal consolidation and lower inflation will set off a steady decline in interest rates over the next 12-24 months. The other camp warns that rates may not fall in a straight line, as swings in FII flows, a rapid economic recovery or the impact of a bad monsoon could derail the bond rally or lead to bouts of volatility.

This has reflected in their respective portfolio strategies. Some gilt fund managers, anticipating the moderation in market rates this year, raised the average duration on their long-term gilt portfolios early in 2014, thus reaping big gains from the rising prices. Others have been sceptical of the rate view and have kept their durations very low, thus missing the opportunity to ride the rally.

Asked why there is such a big divergence in gilt funds, Rahul Goswami, CIO- Fixed Income, ICICI Prudential Mutual Fund explains- “This depends largely on how the fund maturity and duration has been managed. We have maintained high duration and did not bring down the maturities on our funds all along, even as yields went up. Our view remains that as long as the yields on the ten-year gilt were at 8.75 or 9 per cent, there was a buying opportunity. This has been quite fruitful for our fund in the last three months. We believe that given the fundamentals today, including moderating CAD, stable currency and with the new government committed to lowering inflation and fiscal consolidation, interest rates could fall by about a 100 basis points over the next 12-18 months.”

Not all 'long term' gilt and income funds have stayed true to mandate either. Many have played it safe by reducing the portfolio duration. Dhawal Dalal, Head of Fixed Income at DSP BlackRock Mutual Fund explains that staying true to mandate has worked in favour of long term gilt and income funds in recent times; but it dented returns last year. He says - “The best way to measure performance of gilt funds is to compare them to the benchmark 10 year g-sec. As to why gilt funds have negative returns for one year, one must keep in mind that last year around this time, the 10 year g-sec was trading at a yield to maturity of 7.5 per cent. Now it is trading at about 8.65 per cent. That 115 basis point hardening of yield had wiped out almost one year worth of accruals.”

Of course, the other reason for return divergence between debt funds is the wide difference in their expense ratios. In most fund categories, the most expensive fund charges 100-150 basis points more than the cheapest one. Thus, costs could have also played a big role too in return divergence.