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Debt on Top

High returns in Bond funds induced by successive rate cuts seems to converge with the compressing yields on G-Sec funds.

Bond fund investors are not complaining! Even as equity markets continue to be in an abyss, it's a never ending bull-run on the bond markets. With successive interest rate cuts in a short period, bond funds have posted gala returns since the beginning of the current calendar. The gains were sharper in April, with buying in the new fiscal coupled with hopes of yet another rate cut, bidding up bond prices.

For the one-month ended April 30, the average return from the Value Research category of medium-term debt funds was 1.2% or an annualised 14.4%, up from an annualised 4.08% in March this year. The gains for bond funds were two-fold - rally in government securities (G Secs) with maturity of over 11 years and aggressive buying in corporate bonds. Thus, funds with an ideal combination of the two segments have emerged on top. "Last month was particularly good for corporate bond funds since there was big buying (for corporate debentures). The spread between a government security and corporate paper, which had widened to as high as 120 basis points has now come down to 90-95 basis points,'' says Shailedra Jhingan at Birla Sunlife AMC.

Simply put, if a five-year triple A bond was earlier offering a return of 11.2% against a 10% yield on a G-Sec with a similar maturity, it is now down to 10.90%. "Most corporate bonds have a maturity of five years or less. While these bonds have gained, G Secs in the same maturity spectrum have remained flat. Hence, the compression in yields,'' says Pijush Das, head-debt markets, SBI Mutual Fund.

The month also saw a convergence of returns between bond funds and long-term government security funds, though traditionally, the latter has lead the former by a wide margin in times of a rally. While most gains in government bonds have come in the plus 11-year maturity, long-term gilt funds were largely not invested in that segment and hence could not notch up extra gains.

Going forward, fund managers see a further compression in spreads between corporate paper and G-Secs. For one, unlike the fag-end of last year, when there was a deluge of corporate paper in the market, fresh issues are not coming to the market. The supply of issues could only reduce, with banks allowed to lend at below PLR rates to companies. Two, a number of nationalised banks have been very actively buying corporate paper in the last six months. This has lead to a further increase in demand. "The spread could narrow to as low as 75 basis points once corporate bonds are demateralised. This will take away a part of the premium, which is charged due to settlement hassles,'' says Suresh Soni at Kothari Pioneer.

While bond funds have posted impressive returns and the outlook is positive, investors will do well by not attempting to invest with a short-term focus. Bond markets are also no longer insulated from the vagaries of the global economy and have turned volatile. Any instability, say on the rupee front could mar your returns as happened in July last year. Further, with successive cuts in interest rates, there may be gains in the short-term but returns will come down in the long-term. For instance, the one-year return on April 30, 2000 was an average 13.63% from bond funds. It is now down to only 10.74% for April 30, 2001. Thus while lapping up the gains in the current rally, investors should re-align their expectations for the long term.

Bonds do well when interest rates are falling, so they've been a good bet in recent months. But sooner or later, interest rate will stop easing.