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Bond funds ride high on rate cuts

Riding high on the bank rate cut, bond funds have posted ballistic returns. However, do not invest with a short-term perspective

Bond funds have posted ballistic returns since the beginning of the current calendar with the rate cut on February 16 adding to the glitter. The Value Research Category of 35 open-end debt funds has posted an average return of 1.34 per cent for the one-month ended February 23, 2001. In the week since the RBI reduced interest rates, bond funds have galloped, posting an eye-popping annualised return of nearly 24%.

For the chart busters, most returns have come from a high exposure to government securities where prices have seen a sharp spurt. For instance, Zurich India High Interest, with a 37% investment in sovereign bonds, has posted a return of 0.70% (annualised 36%) in the week after the rate cut.

Surely, with ample liquidity in the system and expectation of a further rate cut (both domestic and in the US), bond funds are dishing out sumptuous returns. Yet, investors will do well by not joining the debt fund bandwagon for short-term gains. While bond markets do not reflect even a fraction of the volatility present in equities, any adverse development still holds the potential to upset your applecart.

Apart from the expectation of another rate cut, the bond markets have now set their eyes on the budget that will reveal the size of the government's borrowing programme for the next fiscal. "Market estimates for the current year are in the region of Rs 1.15 to 1.25 lakh crore. A borrowing program bigger than this could see a sell off in the bond markets,'' says Rajiv Anand, fund manager, ANZ Grindlays AMC. "Budget surely holds the key. While we are bullish, we have still brought down the maturity of our portfolio since its better to be cautious around the budget,'' says Dhawal Dalal at DSPML Mutual Fund.

Fund managers also believe that the budget will bring down the coupon on the government- sponsored small saving schemes. This will bring down the government's interest burden, which has been on the rise and adding to the fiscal slippage. "A cut in small savings will signal lower lending returns across the economy and raise hopes of another cut in interest rates by RBI. If it does not happen, we could see a bearish mood in the bond markets,'' says a fund manager.

The outlook is surely upbeat and another rate cut in the US could add the third dimension and further boost returns. However, since the market has already discounted certain events another rate cut and reduction in coupon on government's small saving schemes, any delay or its non-occurrence could trigger a major sell-off and maul the returns from debt funds. Thus, with some key imponderables, enter bond funds with a long-term perspective. In case the budget and the RBI meet market's expectation, the gains will be all yours. If not, a long-term stay will surely iron-out the volatility and still provide normal returns.