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Debt funds: What to do now?

Losses from rising interest rates have brought home risks from interest-rate calls

Debt funds: What to do now?

If there is one big takeaway from the battering that some debt funds received in 2017, it is that it doesn't pay to take the markets for granted.

Falling interest rates over the last three years gave many fund managers and debt fund investors the impression that taking duration calls was the easy route to earning high returns from bonds. Investing in long-term gilt and dynamic bond funds also seemed to deliver easy rewards when compared to taking on credit risks in income or credit-opportunities funds.

But, in 2015 and 2016, if episodes of defaults and downgrades on corporate bonds (Amtek Auto, JSPL episodes) served as a sharp reminder on credit risks, in 2017, the losses from rising interest rates have brought home risks from interest-rate calls.

Stay off duration now
Credit funds rely on the fund manager's ability to assess the default risk on the bonds he owns. But duration funds rely on the fund manager's ability to jump into or out of long-term bonds at just the right times in the interest-rate cycle. Events over the last five years have shown that duration calls can go just as wrong as credit calls.

What's more, if credit risks usually manifest in a one-off fashion in individual funds, duration risks often hit almost all the funds in long-term debt categories at the same time. Comparing the calendar-year returns on gilt funds between 2016 and 2017, for instance, it is clear that all of the 36 funds in the long-term gilt category have suffered big declines in their returns as the rate cycle turned. The category saw average returns fall from 15.5 per cent in 2017 to a measly 2.3 per cent in 2016.

The difference between individual long-term gilt schemes is only one of degree. The 'best-performing' fund saw its returns fall by 8.2 percentage points while the worst one saw its returns battered by 16.3 percentage points (that is, its returns fell from 16.8 per cent in 2016 to 0.5 per cent in 2017).

Surprisingly, many funds billed as 'short to medium-term' gilt funds suffered big return blips as well, with their returns falling by 4 to 6 percentage points between 2016 and 2017. But these funds managed to get away with a slightly better return picture. Their 2017 returns averaged 5.6 per cent compared to half that return on long-term gilt funds.

But while gilt funds were only sticking to their mandate by buying the rate-sensitive G-secs, it is dynamic bond funds that have proved to be the most disappointing of the lot. As the rate cycle changed between 2016 and 2017, they have behaved much like long-term gilt funds. The dynamic-bond category has seen its average returns dip from 13.4 per cent in 2016 to 3.4 per cent in 2017. The dent to returns in their case has ranged from 7 to 11 percentage points.

In short, though gilt funds and dynamic bond funds manage to make the most of a trending market when rates are heading one way, they have found it difficult to call a reversal in trend or position their portfolios in time for it. A study of the average portfolio maturities of all the long-term gilt funds suggests that many funds have cut their average maturity from double to single digits over 2016-17. But they still haven't managed to prune them enough to escape losses from the unexpectedly sharp spike in rates.

The lesson for debt-fund investors is simply that a buy-and-hold strategy may not work with gilt funds, whether of the short-term or long-term variety. Ditto for dynamic bond funds, which are supposed to take over this call from the investor. It is clearly up to the investor to gauge the direction of interest rates while investing or setting return expectations from these fund categories.

Presently, with many factors pointing to a further uptrend or at least two-way movements in interest rates, it appears best for retail investors who can't take so much volatility to move to the short-term, liquid and ultra short-term categories. These funds can actually benefit from rising corporate-bond yields as they replace their holdings more frequently and they won't suffer high return volatility if rates begin to fall again.

Today we mentioned the first key takeaway from the recent bond-market mayhem. In the next few days, we will mention the rest.