Should you exit debt funds?

 Tanvi Varma        Print Edition: November 15, 2009

A year ago, the unfolding global economic crisis put equities on the blacklist and real estate out of reach. Debt funds, however, were seen as a hot investment. Credit worries and a slowdown in the US economy were pushing investors towards bonds and government securities markets.

In fact, investor interest in debt funds saw a resurgence in early 2008. At the time, domestic and global economic indicators showed that interest rates were near their peak. Soon after, the repo rate (the rate at which banks borrow from the RBI), the benchmark for general interest rates, touched 9 per cent (see chart). Clearly, this spelt bad news for the economy, and with inflationary pressures persisting, the RBI embarked on a rate-cutting spree in October 2008. After hovering around 7.75 per cent for most of 2007 and 2008, the repo rate has come down from its peak of 9 per cent at the end of 2008 to 4.75 per cent now. This is the lowest it has ever been. The result has been a decline in the 10-year government securities yield, which came down from a high of 9.1 per cent in July 2008 to 5.82 per cent in January 2009.

How does this affect our debt investments? The falling yield from government securities leads to an increase in bond prices since the basic property of a bond is that its price moves inversely with the yield. So, when interest rates come down, bond prices go up and the net asset values (NAVs) of debt funds rise. Conversely, if bond yields go up, there is a reduction in bond prices and hence the NAVs of debt funds come down. The current yield relates the annual coupon interest to the market price. This is presented by the following formula: Current Yield = (Annual Interest / Price)

So, apart from a fixed coupon rate of a bond, an additional component of capital appreciation comes into play with changing prices.

In fact, due to steep rate cuts, bond prices moved up and long-term debt funds as well as gilt funds delivered astounding returns of up to 20-30 per cent during this period. However, like all good things, this too came to an end. The demand and supply of government paper is an important factor in determining the movement of bond prices and their yields. So, although the RBI has not increased interest rates, the yield on the 10-year government bond crept up from a low of 5.82 per cent in January 2009 to 6.57 per cent in March 2009, and then to 7.41 per cent in October 2009, in light of the government's massive borrowing programme.

The RBI, looking for signs of economic recovery and inflation, is not going to make any further cuts in interest rates, and may in fact take steps to reduce liquidity. In fact, interest rates are likely to remain volatile in the short term before moving up again. If this happens, the capital appreciation component of returns is likely to be low in the coming months.

“With growth picking up and inflation likely to rear its head towards the end of the year, we expect yields to move higher in the medium term to 7.5-7.75 per cent by March 2010,” says K. Ramanathan, Vice President & Head, Fixed Income, ING Investment Management India. In fact, with the base effect coming into play and in the wake of a rebound in global commodities prices, the RBI has already upped its inflation expectation from 4 per cent to 5 per cent by March 2010.

Where does this leave us right now? Typically, when the economy slows, interest rates fall and debt funds provide good returns. This happened during 2000-02, when repo rates came down from a dramatic peak of 16 per cent to 8 per cent and bond funds delivered astronomical returns. But as the economy starts to recover, (the US economy seems to be reviving and corporate earnings in India have improved), interest rates begin to rise or remain at the same level. In the short term, ample liquidity and increased foreign fund flows will enable the government to manage its borrowing, reckon experts. “But the market runs the risk of possible rate hikes by the RBI, starting 2010,” says Sujoy K. Das, Head, Fixed Income, Bharti AXA Investment Managers. Having said that, fixed-income investments would still give superior risk-adjusted returns over the inflation rate in the medium to long run, he adds. Investors should hold their debt funds as long as they are content with their asset allocation, but should keep a watchful eye on the RBI’s rate action, he says.

Options for Investors
Clearly, with the decline in interest rates, fixed deposits, which once seemed attractive, have lost their lustre. The RBI has been persistently asking banks to reduce their lending rates. This has been combined with a reduction in deposit rates. Deposit rates for 1-3 years’ maturity in public sector banks have come down from 9.5-10.75 per cent in October 2008 to about 7 per cent now, and could probably move lower. If we factor in the tax implication, in the highest- income bracket, the post-tax returns would be a meagre 5 per cent.

A few corporate FDs and nonconvertible debentures offer attractive interest rates, but these are more suitable for investors willing to take some risk, depending on the quality of the paper and compromising on liquidity. A good option for investors who have a time horizon of at least a year would be the income or gilt funds, says Ramanathan. However, one must revise one’s expectations, as erstwhile returns of 15-20 per cent are likely to reduce to 6-8 per cent.

For investors with a time horizon of six months to one year, Ramanathan recommends shortterm income funds, which typically invest in corporate bonds with a duration of 1-3 years. Generally, the prices of long-term bonds are more vulnerable to a firming up of interest rates than short-term bonds. So, even if rates inch up, these funds will be attractive. They also have the potential to outperform liquid funds, adds Ramanathan. At the time of writing, the RBI was expected to keep all policy rates unchanged in its second quarter monetary policy review on October 27 (although a CRR hike could not be ruled out because of rising inflationary pressure).

For ultra-short-term investments, liquid funds continue to be a good option since the drop in yields has been combined with a fall in liquidity risk and interest rate risk. These funds would typically give 50-100 basis points over the overnight call rate, says Bekxy Kuriakose, Assistant Vice President and Senior Fund Manager, DBS Cholamandalam Asset Management. Though the returns from liquid funds may have deteriorated in line with the money market rates, these funds remain the safest option since they invest in instruments that are not affected by interest rate movements, she adds. One could also look at liquid plus funds that have a slightly longer duration.

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