In debt funds, as in equity funds, staying invested over an entire cycle can help smooth out the impact of interest-rate cycles on your returns
19-Jun-2018 •Aarati Krishnan
Just like in the equity market, bond markets too move in cycles. Investors who are worst hit by timing issues are those who get in at the bottom of a rate cycle and withdraw in panic when rates begin to rise. But in debt funds, as in equity funds, staying invested over an entire cycle can help smooth out the impact of interest-rate cycles on your returns.
Think of an imaginary investor who didn't know anything about timing and invested in debt funds at random in December 2008 - absolutely the worst possible time to invest in debt mutual funds. This was a month when the yield on the 10-year gilt had hit rock bottom at 5.2 per cent. The rate proceeded to shoot up to 8 per cent within the next couple of years. If the investor had sold his fund in panic within a year or two of that investment, he would have had very poor returns to show for his trouble. But if he held on, that timing mistake did not matter as much. If he held his debt funds till date (December 2008 to April 2018), he is likely to have earned a CAGR of 7.3 per cent. That is the average debt-fund return in this period.
Now consider another investor, a smart cookie who invested in debt funds in July 2008 - exactly the right time when market interest rates were at a high of 9.3 per cent. If he held on till today, his debt fund is likely to have managed a 7.8 per cent CAGR (this was the average debt-fund return from December 2008 to April 2018). You will notice that this return is only 50 basis points higher than the first investor's returns, despite timing the investment really smartly.
This shows that if you hang on for the long term, ups and downs in interest rates tend to balance out the impact of both good and bad initial timing on your returns. In fact, debt markets are even better than equity markets at evening out the timing impact because only a part of the bond investor's returns come from capital gains. The accrual income in debt funds flows in regularly like clockwork and bolsters your returns, irrespective of whether you invest at peak rates or rock-bottom rates.
So the first lesson about debt-fund investing is that if you aren't sure about the timing, invest with a minimum five-year horizon. If you got into a debt fund at the bottom of a rate cycle and are facing negative or sub-par returns after rate increases, don't sell in panic. Wait for the cycle to play out so that you can make a better return.
This is part of a series of stories on debt funds. Read here.