Bond with the Best

First, the double trouble! In the past one year, not only would you have felt the blow of rising commodity prices, your investment in debt too may have generated negative real returns, leaving you with a less than expected surplus. This typically happens when inflation is higher than the return generated by the assets you have invested in. We can attribute the decline in returns from debt funds to the frequent policy rate hikes announced by the Reserve Bank of India (RBI) to tame rising inflation.

Since March 2010, the RBI has increased the repo rate (the rate at which banks borrow from the RBI) by 250 basis points (one basis point is one-hundredth of a percentage point), leading to an increase in the benchmark 10-year government securities (g-sec) yield to maturity by more than 50 bps. This led to a fall in the net asset values (NAVs) of debt funds, thus generating lower returns on your debt investment. Interest rates and bond prices tend to share an inverse relationship—when you buy or sell a bond in the market, like most debt funds do, the price tends to fluctuate based on the prevailing interest rates. A bond carrying a 7% yield, for instance, looks less attractive when interest rates rise to 8%. Hence, this bond will be sold at a discount to compensate for the current yield in the market. Conversely, if interest rates fall, your original bond becomes attractive, which drives the price up.

“Typically, in a rising interest rate scenario, one should invest in assets with short-term maturities since assets with long-term maturities tend to lose out more”, says Ganti Murthy, head of fixed income, Peerless Mutual Fund.

In general, funds holding a portfolio of bonds with longer maturities see more price fluctuations due to the change in interest rates with the underlying portfolio suffering the most on mark-to-market valuation. This can be seen in the performance of debt funds wherein long-term debt and gilt funds have shown relative underperformance compared with their short-term counterparts. Having generated returns of only 5.5% and 4%, respectively, your investment in long-term debt and gilt funds would have translated into a negative real return of 4% on your portfolio, keeping in mind inflation at about 9%.

On the other hand, short-term debt funds and liquid funds have managed to return more than 6.5% in the last one year. “Depending upon their relative risk profiles, debt funds have largely delivered to mandate, given the sharp readjustment in the interest rate environment,” says Suyash Choudhary, head of fixed income at IDFC Mutual Fund.

Performance Report

In the past one year, funds with longer maturities have significantly underperformed short-term funds.

To take an example, an investor who invested in a three-year bank deposit at approximately 6% a year ago will incur an opportunity loss with deposit rates having risen to 9.5%. Only when these investments mature, can the money be deployed at current rates of 9.5%.

If you look at it, short-term bond funds, which are typically recommended for an investment horizon of six to nine months, have also returned approximately 5-6% over the last year.

Having readjusted to the current market yields, portfolio yields of these funds would now be in the vicinity of 9.5-10%. These funds have scored better even over the three-year and fiveyear periods.

In the present scenario of rising yields, short-term and liquid funds invested in short-term assets and when those matured, the funds were reinvested in higher yielding assets. “This strategy led to liquid funds giving better returns than other funds in the medium term”, says Peerless Mutual Fund’s Murthy.

In fact, call money market rates(liquid funds investment) have risen from a low of 3.5% in March 2010 to 7.4% today. The last one year has seen a rise of 400 bps in short-end rates, which according to IDFC Mutual Fund’s Choudhary is a sharp adjustment in rates by any standards. However, analysts say we could be close to the peak on short-end rates.

THE BRIGHT SIDE

The rising interest rates augured well for debt investments that offered fixed maturities, considering these are held until maturity and do not bear any mark-to-market risk. That was the reason fixed maturity plans have been in the reckoning of late due to their investment in fixed-income instruments such as certificates of deposit, the rate on which has moved up to almost 10% from 5% last year. Since these funds invest into deposits maturing in line with the investment horizon of the fund, there is no mark-to-market risk involved. Further, the benefit of double indexation rendered returns from these funds as good as tax-free after a period of one-two years (due to the high inflationary environment).

“Debt as an asset class should be looked at only if your goal is up to three years”, says Gaurav Mashruwala, a certified financial planner. “You can invest in a fixed maturity plan that matches with your goals in terms of maturity. This way you need not worry about the interest rate movement.”

Further, fixed deposits offered by banks and companies too became hot investment favourites as banks have raised their deposit rates up to 500 bps from March 2010 to March 2011 across maturities. Deposit rates offered by private sector banks range from 8-10.10% for maturities of one year to three years, while the public sector counterparts are offering up to 9.75%. On the other hand, company fixed deposits are offering up to 11%. However, on a post-tax basis for someone in the highest tax slab of 30%, these aren’t as attractive.

“Company fixed deposits should be lower down on the priority list considering that these are unsecured loans with high risk”, says Mashruwala.

Some companies offering high interest rates are the ones that have been unable to borrow money from financial institutions. You should understand the rating of the company, its balance sheet, the borrowing cost, etc., before investing in a company fixed deposit.

Rising Rates

Since March 2010, the repo rate has gone up by 250 bps, while the 10-year government security yield has increased by 40-50 bps.

LOOKING AHEAD

Analysts expect another 50-75 bps hike in repo rate this year, given the stickiness of inflation at current elevated levels and the RBI’s determination to control it. “Although the government bond yields seem to have priced in the trajectory for the RBI’s policy rate hikes, we could see the yield touching 8.5% before recovering,” says Peerless’s Murthy.

As the government continues to be the largest borrower in the market, the bond yields will find it difficult to perform in the near term owing to the incessant supply of government paper. “In a scenario like this, investors should remain invested in short-term bond funds. In fact, they should look to increase exposure with an investment horizon of 9-12 months,” says IDFC Mutual Fund’s Choudhary.

Of late, debt funds are managing their duration in line with the changing shape of the yield curve. In the earlier phase of the current cycle, when the yield curve was fairly steep, reflecting adequate liquidity and expectation of gradual interest rate hikes, the IDFC SSI Medium Term Fund, for instance, was investing in higher duration assets aiming to benefit from higher accrual and possible gains from ‘run down’ of average maturity. However, as during last calendar year the curve started flattening out, the fund proactively cut duration with an objective to reduce volatility from rising interest rates. “Ideally, when interest rates are going up, floating rate is your best option”, says Mashruwala. Depending on your tenure, this could be investing into liquid funds, liquid plus funds, shortterm funds or floating rate funds.

Long-term rates will also likely peak over the next three-six months as the RBI completes its near-term rate hike cycle and bulk of current year’s government bond supply gets absorbed by the market.

According to Murthy, the RBI is likely to pause sometime soon and refrain from raising policy rates as it would hurt growth. Thereafter, one could look at long-term debt funds, but with caution.

“We still haven’t witnessed a reversal in rates like the one during 2001 to mid-2003, wherein debt funds returned as high as 20% per annum”, says Mashruwala. One should not jump onto these funds too quickly considering your riskreturn trade-off is not going to be that high, he adds.