Tackling Diminishing Returns | Value Research Understanding the nature of bond funds is essential if one wishes to be a successful investor in this period of falling returns. Realigning expectations is also central to this process.
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Tackling Diminishing Returns

Understanding the nature of bond funds is essential if one wishes to be a successful investor in this period of falling returns. Realigning expectations is also central to this process.

It has been a great and glorious party. In all probability it is now over. The year-to-date returns of medium-term debt fund category have come down to 2.81 per cent as on June 11, 2003. On an annualised basis, this means a return of just over 5.5 per cent. Even with some trading on government securities, fund managers can push returns into the region of 6 to 7 per cent. And this is exactly what they have been shouting themselves hoarse about in recent months. This is a far cry from the 15 per cent plus returns that we have witnessed in the past two years.

But then the yield on the benchmark ten-year paper fell by 186 basis points in 2002 and 300 basis points in 2001. This year a 50 basis points fall is all that is expected. These falling yields were the driving force for debt mutual funds. As interest rates moved down, older papers carrying higher coupon became more attractive. Funds traded on these papers to generate returns far in excess of the meagre coupon. But with any further fall being limited, the scope for trading profits is low. Bond markets are returning to a situation of normalcy where coupon income is the main source of returns. In this "normal" bond market one must understand the nature of bond funds so that effective steps can be taken to tackle diminishing returns.

Bond Funds are Commodity Products

It is important to realise that income funds are largely commodity products. This means there is not much to differentiate between one income fund and the next. For that matter the top ranking income fund in any given period will largely resemble the 5th ranking fund as well as the 10th ranking fund and so on. So it is a futile exercise to be happy over your bond fund beating its peers by 0.5 per cent or be unhappy if it is losing to its peers by 0.5 per cent.

The "superior" performance of one bond fund over the other will largely be a function of its portfolio maturity. Greater the maturity, greater will be the returns when markets are bullish. But when times turn bearish, funds with lower maturity will be better able to hold on to returns and move up the performance charts. In all these phases the difference between top funds and the rest is not substantial. So there is not much sense in chasing returns in bond funds.

This similarity in bond funds can also be seen from their portfolios. Most bond funds allocate 30 to 40 per cent of their portfolio to gilts and 50 to 60 per cent to bonds. However, PNB Debt is one fund that has more than 80 per cent of its portfolio in gilts and is more of a gilt fund than a bond fund.

Commodities Compete on Price

The distinguishing feature of a commodity is its price. This is the same with income funds. The recent trend in the industry towards offering lower expense ratios for institutions is the biggest example of this trend. As returns fall, funds are reducing their expenses to continue to attract institutional investors. And this is the single feature, which is common to all the institutional plans. So if the big boys of the investing world are ultra-sensitive towards expenses, so should you be. Do check the expense ratio of your fund and make sure it is not out of line with that of similar funds. The maximum expense a bond fund can charge is 2.25 per cent, while the category average is 1.5 per cent. Some funds do charge the maximum expenses which are allowed and if your fund does so then you should have a serious look whether it has a place in your portfolio or not.

Not Just Returns

Bond markets have witnessed volatility of an unprecedented nature. The category has posted negative returns for January and March this year. The first quarter of calendar 2003 is also in the red. So it is not just returns, which are important, but the risks associated with these returns also. Do take a look at your fund's Sharpe ratio. A fund may be generating lower returns but it may compensate by being less volatile. On the other hand higher returns may be accompanied by higher volatility. In both cases the risk-adjusted returns can be very close to each other. Therefore it is important to understand what one wants—high returns and high volatility or low returns with lower volatility.

Investment Horizon

Your investment horizon becomes very important when markets turn volatile. When markets were on a secular bull run, a three-month stay in an income fund was also rewarding. Not any more. Volatility may erode away returns so make sure your duration of stay is appropriate for the particular fund. Medium-term bond funds are suggested when the investment is for a period of a year or more.

While looking at fixed income products, one can also take a look at Public Provident Fund and post office deposits. Of course, these offer much less liquidity and convenience than mutual funds. On the positive side they offer tax incentives. When bond funds may deliver 6-7 per cent, the higher returns from PPF may look more attractive. But the lock-in periods of these instruments should also be factored in. A big risk in these instruments is that their returns are not linked to the market, and this has the possibility of causing problems in the future. When a ten-year government paper gives a return of 6 per cent, from where will these instruments generate 8 per cent, especially when they do not trade? The daily NAV disclosure of your fund tells you everyday what your money is worth and reduces the scope for unexpected shocks.

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