For more than two years, debt fund managers were screaming that double digit returns from debt funds were not sustainable. Bond markets took heed of this in 2003 and the medium term bond fund category—the mainstay of any bond fund portfolio—promptly delivered 7.52 per cent. While this may look better than what bank fixed deposits and tax saving bonds promise, it pales in comparison to 15 per cent plus, that these funds generated in 2002 and 2001.
But then yields fell by 186 basis points and 300 basis points in 2002 and 2001 respectively. In comparison the yield on the benchmark ten-year government security dropped by just 93 basis points in 2003. Of greater significance was the fact that 2003 witnessed two periods of sustained volatility.
Thus at the start of the year, the war in Iraq destablisied bond markets. Between January 22, when bond yields were at their lowest point so far and February 14, when they went up to the year's high the average bond fund lost 3.28 per cent. This is the worst loss recorded by bond funds on average in any given period since they came into existence.
Then in a single day all these losses were wiped out. Year-to-date till February 27, the category's returns stood at minus 1.83 per cent. Then, on Budget day as the rates on several small savings instruments were cut, year-to-date returns moved up to 0.18 per cent. On the whole, it was an average movement of 2 per cent in a single day. And then there was more to come. In March, bond yields hardened once more. Bond funds lost 0.32 per cent in the month. The cumulative impact of these movements was that the category ended the quarter with a loss of -0.14 per cent. For the first time in their history, medium term bond funds, as a category generated negative returns over a quarter.
There were some good months after this and it seemed that the bond fund juggernaut was on a roll. By October there was an across-the-board expectation that some key interest rates would be cut in the credit policy. When this did not happen, and SEBI and RBI asked for unlisted bonds to be listed, bond markets were once again thrown into chaos. Between October 17 and November 18, the average bond fund was down 1.08 per cent.
The combination of these two periods brought bond fund returns down to the reality of single digit returns.
In view of the volatility that bond funds have exhibited, it is important to realise that loss of capital is a possibility in bond funds. This is accentuated if the holding period does not match that of the fund. For medium-term bond funds, a holding period of one-year plus is essential if volatility is to be tackled. For shorter periods, look at short-term funds. If higher returns are sought, then a dash of equity will be required and MIPs could be an option. But do keep in mind that the risks with MIPs are higher than a pure bond fund.