Your debt-fund strategy now: Avoid long-duration bonds

A mid the outbreak of the pandemic, the last one year has been quite eventful, even tumultuous, for the debt markets. It all started with the shutdown of six yield-oriented debt funds at Franklin Templeton. Spooked by this, investors turned risk averse, which resulted in massive outflows from credit-risk funds. Then came liquidity infusion and aggressive rate cuts by the RBI to counter the pandemic-led slowdown, and long-duration and gilt funds revelled in the party. Lately, rising bond yields have resulted in mark-to-market losses in debt funds.

What further added to the commotion was changing strategies to 'profit' from the debt markets. You may have across all sorts of jargon - barbell strategy, carry, roll-down strategy, etc. In the last few months, investing in the dynamic-bond category to sail through a volatile interest-rate scenario became popular. More recently, investing in target-maturity funds seems to have become the buzzword. All this has definitely confused the average debt investor, who just desires safety of capital and somewhat higher returns than bank deposits.

Here, we seek to simplify things for you and tell you what you need to do. One thing is clear at the outset: as an investor, you shouldn't have to change your strategy with changing market conditions. That's especially true for debt-fund investors. Whether it's equity funds or debt funds, your investment strategy should be such that it can stand the ups and downs in the market.

The mystery of negative returns
For the last few months, a spike in bond yields has resulted in many debt funds delivering subdued, even negative, returns over the short term. What's going on here? For that, first let's understand, the classic inverse relation between bond yields and prices.

The yield on a bond is obtained by dividing the interest rate on the bond by its price. So, if the bond price falls, the yield goes up. How does this affect the NAV of a debt fund? The NAV of a fund is derived from the prices of the bonds that it holds, so if bond prices fall, the NAV falls, which reflects as a loss.

But what led to the fall in bond prices? The RBI announced retracting Rs2 lakh crore of banking funds through a 14-day reverse-repo operation in January 2021. Effectively, banks were told to take money out of the debt market and park the surplus with the RBI. This sell-off in the debt market resulted in a fall in bond prices and hence a rise in the yields.

Further, a higher-than-expected government-borrowing programme of around Rs12 lakh crore for FY22 was announced in the budget. This has also contributed to a surge in yields. High government borrowing leads to a large supply of government bonds. This easy availability of bonds depresses bond prices, thus causing a rise in yields.

Also, there is an expectation that the interest rates may have bottomed out now and that the rate cycle may reverse from here, i.e., the interest rates may start going up. By how much and at what interval - that's anybody's guess but the debt markets have taken the cue by pushing the yields up. Globally, rising commodity prices and inflationary expectations, thanks to stimulus programmes to fight the pandemic, have also contributed to the rising yields.

What should you do?
While most of the factors discussed above are not in our control, what we can do to mitigate their impact very well is. Here's the first thing that you can do to counter the risk of rising yields.

Avoid long-duration bonds
In a rising-yields scenario, long-duration bonds are most vulnerable and so are funds investing in such bonds. Why's that so? That's because such bonds will likely suffer a dramatic fall in their prices. As interest rates rise, any new bond issuances will have to offer higher interest, thus making the existing bonds relatively less attractive as they'll carry lower interest rates. So, their prices will correct. This will result in the erosion in NAVs of long-duration debt funds. Since the RBI cut rates aggressively last year amid the pandemic scare, investors subsequently saw a rally in long-duration funds. However, investors are now seeing negative returns on the back of rising yields. Look at the chart 'Is the rally in long-duration funds over?', which shows the calendar returns of these funds in 2020 vs trailing three-month returns. This clearly shows how they have suffered. So, these funds are only meant for tactical allocation during times of falling interest rates and it seems we are not in that kind of scenario right now. So, to keep it simple, stay away from such funds.