Set Sights Lower

Expect less from your bond funds in 2018 as rate cut cycle seems to be all but over.

By Renu Yadav  
Saturday, December 9, 2017

Debt fund investors are unlikely to end 2017 with the 8 per cent-plus returns they have been used to over the past two-three years ever since the interest rate cut cycle started in 2015. Dynamic bond funds, which delivered 13.41 per cent returns on an average in 2016 and were the best performers, have returned just 4.18 per cent so far (as on November 22), as per the data provided by Value Research. Debt income funds, which invest in higher maturity papers (and are high-risk) have delivered 5.36 per cent this year compared to 11.84 per cent in 2016. Such returns do not justify the kind of risk income funds take.

Higher Yield

The reason behind the poor returns is the rise in yields in the second half of 2017. A rise in yields reduces prices of bonds.

The journey of 10-year benchmark bond yields in 2017 can be divided into two parts. The first, between January and August, saw a fall from 6.99 per cent to 6.42 per cent as consumer price inflation touched a low of 1.46 per cent in June. Global crude oil prices remained subdued during this period and with inflation firmly under control, the Reserve Bank of India, or RBI, cut the repo rate by 25 basis points (100 basis points is equal to 1 per cent) in August, triggering a rally in bond prices. However, of late, yields have started rising again due to fear over rising inflation. The 10-year benchmark paper yield moved up from the lows of August to 7.10 per cent in November. Inflation touched a seven-month high of 3.58 per cent in October on account of rising crude oil and food prices. This is bad news for bond investors as bond prices will fall further if the trend continues.

Trend Reversal

Debt funds (especially those that invest in long tenure papers) do well when rates fall as prices of bonds held by them go up when yields go down. The future returns of debt funds will depend on the RBI's monetary policy stance, which in turn will depend on inflation and fiscal discipline of the government given the huge banking recapitalisation and uncertainties over tax collected under the Goods and Services Tax regime.

Here, experts say that inflation is likely to rise from the current level, though it may remain in the RBIs comfort zone. "Going forward, headline inflation is likely to trend higher given the base effect and emergence of pricing pressures despite the recent cut in GST rates on some items. We expect CPI to average around 4.4 per cent in 2018 compared to around 3.5 per cent in 2017," says Dhawal Dalal, CIO, Fixed Income, Edelweiss Asset Management.

Therefore, a rate cut is unlikely to happen in the December 2017 monetary policy review, though it is difficult to say if we are at the end of the rate cut cycle. "We see a low probability of rate cut in the upcoming policy. It's important that the RBI gets comfort on the incoming data on inflation before effecting a rate cut. While we don't expect aggressive easing, there is still time before we can call it the end of the easing cycle," says Lakshmi Iyer, Chief Investment Officer (Debt) & Head of Products, Kotak Mahindra Asset Management Company.

What Should Investors Do

With bank fixed deposits offering as much as 6.25-6.50 per cent, it is imperative that investors look for options beyond fixed deposits, though experts say that the rates are unlikely to go down further sharply as deposit growth has been flat and liquidity is not as good as it was just after demonetisation. This will limit the scope for a further rate cut.

Also, rates on small savings schemes such as public provident fund are linked to yields on government securities. Therefore, rising yields are good for those who invest in such schemes.

For debt fund investors, clearly it is time to stay away from debt income funds, which invest in longer maturity papers. In an uncertain interest rate scenario, it is better to invest in papers with shorter maturity, as they are less volatile.

"Long-term debt mutual funds such as gilt funds and dynamic bond funds, which hold securities with higher average maturity, are impacted the most when 10-year benchmark yields rise. Hence, investors should move out of these funds. Also, lower duration bond funds have lower expense ratios and could fetch returns of 8-10 per cent," says Dinesh Rohira, Founder & CEO, 5nance.com.

"We have for long been asking investors to allocate money to short-term funds and/or corporate bond-based accrual funds as core fixed income allocation. This will bring stability to the fixed income portfolio as these funds are usually low on duration relative to bond and gilt funds," says Lakshmi Iyer of Kotak AMC. "Fixed income investors may consider cutting their duration exposure and dividing their investable corpus between products offering average maturity between three-six months and three years," says Ritesh Jain, CIO, BNP MF.

Going forward, the returns may not be as great as in the past three years, and so those investing in debt mutual funds should enter with the right expectations and choose the right fund as per their risk appetite.

 

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