These are bad times for income funds and their investors. Yields on government securities have been hardening over the past two weeks and this has sent the category of income funds into a tizzy. In the year to date so far income funds have lost on average 0.22 per cent. Mediums to long-term g-sec funds have been the worse sufferers with losses of 0.37 per cent.
While there was some volatility in early and mid January the situation has really heated up at the end of the month. The first blow was dealt by the US Federal Reserve on January 28. All through 2003, the US Federal Reserve had said that the interest rates could well stay low for a "considerable period" of time. On January 28 this phrase was dropped and replaced with the statement that "we can afford to be patient when it comes to raising short-term interest rates".
This changing stance spooked investors as it opened up the possibility of a reverse flow of capital to US bonds. This can suck out liquidity from Indian markets leading to a fall in bond prices i.e., hardening of interest rates. Yields immediately hardened and within three days the benchmark ten year paper (GOI 2014, 7.37%) gained 9 basis points to close at 5.23 per cent.
There was some relief then as the interim budget showed a lower budget deficit (smaller borrowings, hence greater liquidity) for the next fiscal and things cooled down a bit. But not for long! On February 5, the Bank of England increased its repo-rate by 25 bps to 4 per cent. And now the looming possibility that the RBI will issue market stabilisation bonds to suck out excess liquidity has further spoiled the sentiment.
In the last two weeks the category of income funds has lost 0.33 per cent. Gilt funds in comparison are down 0.55 per cent. In general funds, which had higher average maturity, have taken a bigger fall in their NAV.
What does the future hold?
This volatility has happened at a time when most fund managers have ruled out a fall in interest rates but expected a measure of stability in the short to medium term. But the market is a stern teacher and expecting the unexpected maybe a better course of action.
If the forecasts of higher economic growth materialise, over the coming years, interest rates are expected to rise. This will mean bad times for fixed-income investors, as falling bond prices will drive down returns from bond funds. Not only this, but sharp fluctuations in yields will result in periods when bond funds will yield nothing or show negative returns as is happening now.
The Way Out
Get used to it for this is how things will be from now on. Lower return expectations from bond funds and be prepared for more volatility. Ensure that the investment horizon from income funds is at least one year. For an investment horizon of less than 6 months move to short-term and floating rate funds. For shorter periods these funds will be better able to preserve capital.
While looking at income funds also consider expenses. A fund, which is charging less, may be able to put something more in your pocket.