Why your debt fund is losing money and what you should do

The 6 per cent correction in stock indices since January has had many folks running around like headless chickens. But bond investors have been facing much greater turbulence for the whole of last one year. For those who invest in debt mutual funds, 2017 has been a shocker.

After three years of predictable debt markets and nicely rising debt-fund returns, debt-fund performance has taken a nosedive in 2017. What's worse, the debt-fund categories that delivered the best show in the three years to 2016, have turned the worst-performing categories in 2017. So, returns on long-term gilt Funds, which averaged 15.6 per cent in 2016, crashed to 2.3 per cent in 2017. Returns on dynamic bond funds plummeted from an average 13.4 per cent to 3.35 per cent. Those on income funds fell from 11.9 to 4.9 per cent. Short-term debt-fund categories suffered less, but saw their returns take a dip nevertheless. The sudden decline in returns has come as quite a surprise to those investors who had jumped from bank FDs or small-savings schemes to debt mutual funds, lured by their stellar returns between 2014 and 2016.

So, what tripped up the returns on debt mutual funds? What must debt-fund investors do now?
Let's first understand why the bond market has gone bonkers in the last one year.

The about turn in rates
If you are a debt fund investor, you probably know that bull markets in bonds are built on the back of falling interest rates.

This is the script that played out between 2014 and 2016. After staying sky high and topping out at 11.5 per cent in the previous three years, consumer price inflation in India (measured by the new CPI combined) began to moderate from the fag end of 2013. Credit it to lower food prices, the meltdown in global oil prices and the bear market in global commodities.

With inflation nosediving, the RBI (and later the Monetary Policy Committee) saw reason to loosen up on monetary policy and give the slow economy a helping hand by steadily slashing the repo rate. It was duly pruned from 8 per cent in January 2014 to 6 per cent by August 2017. When the RBI (or MPC) slashes its benchmark rates, market interest rates usually follow suit. In fact, the markets often don't wait for the RBI to act. They try to anticipate its moves in advance and adjust accordingly. Therefore, market interest rates in India started to swing down right from the end of 2013.

The 10 year government security is the bond market benchmark, like Sensex is the benchmark for the stock market in India. From over 9 per cent in 2013 end, the yield on the 10-year G-sec fell all the way to 6.2 per cent by November 2016. When market interest rates fall, long-term bonds and G-secs see a sharp appreciation in their market prices. Shorter term bonds gain, too, but to a lesser extent.

Therefore, debt fund managers, who gauged the bullish direction of RBI policy right from 2014, started to pack their portfolios with 'duration' (jargon for holding longer-term G-secs and bonds) right then. Some categories of debt funds - long-term gilt, dynamic bond and income - allow their fund managers far greater leeway on stretching their durations. These debt funds, therefore, went the whole hog on long-term G-secs (even 20 and 30 year gilts) to catch a nice ride on the bond bull market. Sticking to their script, as market interest rates headed steadily south between 2014 to 2016, these debt funds notched up high capital gains on their bond holdings. These gains, coming on top of a high starting point on interest rates, delivered a double booster to the returns of long-term gilt, dynamic bond and income funds which played this duration game. The more risks the fund managers took on duration, the headier gains they made in this party.

But from 2016 end, this party began to slow down. The yield on the 10-year gilt began to display two way movements instead of predictably declining. The many factors (discussed below) which added zest to this bond market party began to fizzle out. In August 2017, the Monetary Policy Committee (MPC) spooked the market by cutting its repo rate from 6.25 to 6 per cent, but accompanying it with hawkish commentary and signalling a pause thereafter. As the realisation that the MPC's rate cuts could be over took hold, market interest rates, which had by then turned quite volatile, began to gallop.

Since August, there has been every sign that the three-year old bull market in bonds is officially over. Between August 2017 and February 2018, the one-year G-sec saw its yield shoot up from 6.1 per cent to 6.7 per cent. The 10-year saw a steeper climb from 6.4 to 7.7 per cent. G-sec rates set the floor for all the other bonds trading in the market. Therefore, this rise in G-sec yields has seen interest rates on all other corporate bonds shoot up, too. The average yield on the five year AAA rated corporate bond has shot up from 7.3 per cent to 8.1 per cent in these six months and on six-month commercial paper from 6.7 to 7.9 per cent.

We try to explain to you the reason for the crash of the bond market in this series.