In the last two years, investors in debt mutual funds have had a far more torrid time than those who invest in equities. Interest rates rose, nosedived and then unexpectedly increased again, subjecting debt fund investors to a bumpy roller-coaster ride. The recent Budget too added to the confusion, by increasing both capital gains and dividend tax for debt fund investors.
Amid all this confusion, most investors are likely to have missed the turnaround in debt fund returns. Medium to long-term gilt funds have been the best performing debt fund category so far in 2014, with an absolute return (not annualised) of 6.03 per cent in the last six months (as of July 25 2014). Income funds (which invest in a mix of long term g-secs and corporate bonds) have already delivered a 5.26 per cent gain. If recent returns are sustained, both categories are on course to deliver a double-digit return to investors this year.
Short term debt funds sport a 6-month return of 4.9 per cent while liquid funds have managed 4.3 per cent, on course to serve up 8-9 per cent for the year. So is this a sign that the secular bull market in bonds that everyone has been waiting for, is finally back? Can we expect the impressive returns from debt funds to be sustained?
Is the bull market back?
For investors who park more than 3 year money in debt funds through gilt funds or income funds, the best returns are made when there is a steady fall in interest rates. As rates fall, portfolio managers of these funds have an opportunity to pocket capital gains from rallying bond prices, in addition to receiving interest income. But while both investors and debt managers have been primed for this 'secular bull market' in bonds since last year, there have been several false alarms. The worst one was in July2013, when RBI's rate-cutting spree came to an unexpected halt and it had to hike rates sharply to curtail FII pullouts and rescue the rupee. This severely dented both gilt and income fund returns in 2013.
However, returns have made a dramatic comeback since January this year. For one, with a stronger rupee and political stability, Foreign Institutional Investors (FIIs) have been eager buyers of Indian g-secs and bond. The trend received a further boost from RBI, which after its last repo rate hike in January, has paused, indicating that further action will depend on inflation data and fiscal conditions. Two, with the new government indicating its resolve to keep the fiscal deficit at 4.1 per cent, fiscal consolidation appears to be on track. Three, CPI (Consumer Price Index) inflation has been moderating, falling from 11.2 per cent in November 2013 to 7.3 per cent in the latest June 2014 data. So will all this add up to rate cuts and a rally in bond prices?
Gilts, if you are brave
While there is near term uncertainty regarding the monsoon and its impact on inflation, most fund houses believe that g-sec and bond prices are indeed poised for a rally over the next one to two years. This argues for adding gilt funds with a 3-year view.
For one, with a strong mandate, this government is expected to take tough decisions on fiscal consolidation that the previous regime never managed to take. Reform moves have already been initiated on increasing diesel prices and railway fares. Lower subsidies and curtailed government borrowings are a big positive for bond markets, as this could reduce the excess supply of g-secs always sloshing around in the markets. Lower supply and higher demand adds up only to one thing- rising g-sec prices. Making a case for adding long term bonds to the investor's portfolio, Maneesh Dangi Co-CIO, Birla Sun Life Mutual Fund says- "We have turned constructive on rates in India and believe the rates could be headed down year after year. Any increase in rates due to technical factors be used as an opportunity to invest rather than to escape from duration fund space from here."
Two, the recent FII flows and moderation in CPI has already led to g-secs rallying in the first half of 2014. Rahul Goswami, CIO- Fixed Income with ICICI Prudential Mutual Fund says - "From here on till September, the trading range on the 10 year g-sec could be 8.25-8.60 per cent. We'll have to see how monsoon and consequentially the CPI inflation trajectory pans out in the next six to eight weeks. We are reasonably positive that CPI inflation could average about 7 per cent through the year. We believe by January, it could be 7.25-7.50 per cent, which is well within the RBI's target of 8 per cent. If that is the case, then we could witness a positive environment for interest rates".
"We expect government bond yields to decline gradually starting last quarter of 2014 after sustained decline in inflationary pressures", says Dhawal Dalal, Executive VP and Head-Fixed Income, DSP BlackRock Mutual Fund. With foreign investors aggressively buying Indian g-secs and bonds, market prices have firmed up even ahead of any actual policy action. Yields on the benchmark 10 year g-sec, after hardening to over 9.10 per cent in April had moderated by 40 basis points by end-July, aiding increases in gilt and income fund NAVs.
In keeping with this view, fund managers are advising investors with some risk appetite, to buy into medium to long term gilt funds, especially if 10 year g-sec yields spike to 8.75-9 per cent levels. However, after the surprises of last year, they are careful to warn that playing the gilt fund opportunity is not for everyone as there could be short-term hiccups. Investors can look to handle this volatility either through asset allocation or by mixing corporate bonds with gilts.
"While we are positive on bond prices over the medium term, we did see in the third quarter of 2013 that directional calls on rates can go wrong. While our view on rates is constructive, it is not going to be a very easy unidirectional path. There could a lot of volatility and uncertainty along the way", cautions Amandeep Chopra, Head of Fixed Income at UTI Mutual Fund. He advises that investors add gilt funds to their portfolio in a measured manner. "If investors have a 25 per cent or so allocation to duration (long-term funds) they can stay with it. If they have no duration or exited last year in a panic, then they should raise allocations to long-term funds."
Mix n match
The other view is that investors with a 3-5 year horizon can consider corporate bond funds. Santosh Kamath, Managing Director - Local Asset Management, Fixed Income at Franklin Templeton India holds the view that for an investor looking for higher returns without high volatility, corporate bond funds offer a good alternative to gilt funds. "If you don't want to take a call on the whims and fancies of the market, you can still make good returns from high yielding corporate bonds today. If I am a conservative investor, I may prefer this strategy for my core portfolio", he says. The argument for buying into corporate bond or income funds today is simple. Non-triple A corporate bonds can offer higher yields and the prospect of capital gains from improving fundamentals. Plus, given that such funds usually maintain a duration of 3-5 years, they can gain from falling rates, but expose the investor to lower NAV volatility than gilt funds (which typically have much longer durations).
Brace for moderation
So, if interest rates do begin a secular decline over the next few months, what would that mean for the hugely popular liquid and short term debt funds? Well, these funds may see moderation in their returns. As these funds make their returns mainly from interest receipts rather than from bond price moves, they thrive on periods of tight liquidity, when short term borrowing rates in the market spike up.
But the three-six month debt securities that short term and liquid funds invest in, have already begun to offer lower rates in the last three months. Certificates of deposit and commercial paper now offer rates that are about a 100 basis points lower than in April.
Overall, in debt funds, as with other asset classes, earning a higher return will now mean taking on more risk- whether by way of interest rates or credit.
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