Falling interest rates are good news for bond investors. Interest rates and bond prices share an inverse relationship: any fall in interest rate will lead to an appreciation in bond prices thereby increasing the non-asset value of income funds and vice versa.
Hence, when the interest rate i.e. the repo rate-the rate at which banks borrow from the Reserve Bank of India (RBI)-was reduced by a total 75 bps since the beginning of the year, there were expectations of an increase in bond prices. However, this did not happen.
In January 2014, long-term income and gilt funds, which delivered average returns of 14 per cent and 17 per cent respectively, are now returning 10 per cent and 12.5 per cent respectively. There are various reasons for this aberration. According to Rahul Goswami, chief investment officer (CIO), fixed income, ICICI Prudential AMC, bond markets have been trading cautiously on account of worries regarding monsoon uncertainty, fearing upside in retail inflation, global bond markets-sell off and a probable US Fed rate hike. Besides, the global macro situation, led by Greece continues, to deteriorate.
All these factors put together has led to huge volatility in global bond yields, which also impacted Indian yields.
Further, the movement of the Indian currency along with investment by foreign institutional investors (FIIs) in bond markets have a bearing on fund returns. The Indian debt market bore the brunt of outflow as FIIs withdrew $1.3 billion-the first outflow since April 2014 CY15YTD. "Any selling which happens in large scale tends to have an adverse impact on bond prices", said Lakshmi Iyer, CIO (debt), Kotak Mutual Fund. However, there are high chances of a rate cut in the background of a pick-up in monsoon thus reducing inflation worries and economic factors like a low current account deficit and improving government finances.
"Hence, once the worries over monsoon and global uncertainties subside, RBI could further reduce rates by 50-75 bps in the remaining part of the financial year," Goswami added. The 10-year G-sec yield is currently hovering at around 7.8 per cent and could be in the range of the 7.25-7.50-per cent mark over the course of the year. With a reduction in yield, bond prices could go up leading to capital appreciation. With this hope, investors with a longer-term horizon of more than three years could invest in duration funds since they provide a higher earning potential by way of capital appreciation.