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Tuesday, November 8, 2016

Long Term Debt Funds

 For once, the bond market is mimicking the equity market and wit nessing a rally of its own. The yield on the 10-year benchmark government bonds have softened substantially. Declining yields mean bond prices are inching upwards, since bond prices and yields move in opposite directions. Where does that leave investors in bond funds?

For over a year, debt fund investors held on to long duration funds in anticipation of the interest rates softening. When interest rates fall, bond prices move up, and longer maturity instruments benefit the most from this movement. Long duration funds such as gilt funds and income funds being among them. Despite a cut of over 150 bps in interest rates since early last year, long-term bond yields did not budge much until recently, leaving investors in long duration funds with a bad taste in the mouth.
 

Unsurprisingly, gilt funds have seen heavy outflows since December last year. These investors would be ruing their decision to sell with benchmark bond yields dropping from 7.76% in December to 7.29% now. Gilt funds have benefited from this rally and delivered a healthy 10.35% over the past one year. Short-term and ultra short-term funds, on the other hand, have yielded 8.6% and 8.4% respectively. How should investors position their portfolios as this rally plays out?


Most fund managers admit that the rally could last for some more time, but advise caution against taking any aggressive positions in long-term funds. The bond market appears overenthusiastic about its near term outlook, Inflation is on the higher side, which could prevent the RBI from cutting interest rates anytime soon

 

One of the main reasons cited for the bond market's enthusiasm is speculation that the soon-to-be appointed RBI Governor is likely to be more inclined towards carrying out rate cuts. Current Governor Raghuram Rajan's term ends in September, when his replacement will take over. But not everyone is so enthused. According to R. Sivakumar, Head of Fixed Income at Axis Mutual Fund, while the new RBI Governor is expected to be inclined towards softer interest rates, he doesn't see the central bank cutting interest rates aggressively, irrespective of the governor's preference.

 

Given the current scenario, experts are advising investors to stay focused on shortterm bond funds. Sivakumar points out that as the end of the rate cut cycle draws closer, the window to benefit from a reducing interest rate environment is getting progressively narrower. "Even though we may see one or two more rate cuts, we expect short-term bonds to outperform in the coming months," he adds. According to Jain, yields on the 10 year government bond are likely to touch 7%-7.15% before we witness a rebound, and while a bid on long term bonds may pay off over the next 6-12 month period, shortand medium-term bonds appear to be more attractive on a risk-adjusted basis.

 

Jain adds that he may look to trim duration of his own funds going forward, depending on how the new RBI governor plays his cards. In bond terminology, duration is a measure of the sensitivity of a bond portfolio to changes in interest rates.When fund managers extend or reduce portfolio duration, they essentially buy or sell longer maturity instruments within the portfolio.

 

According to experts, investors should assign more weight to accrual funds in their debt portfolios at this juncture. This includes short term and ultra-short term bond funds.

 

Unlike duration funds, accrual funds or credit funds derive a significant chunk of their returns from the interest income yielded by the underlying bonds. Since these funds do not play on interest rate movements, they don't have as much exposure to risks related to interest rates as duration funds do.

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