FundsIndia Views: Why you should not be exiting debt funds now

If you were to look at the year-ago returns of many of your debt funds and the current returns, you will wonder if you made a wrong choice in investing in debt funds. Many of you also expressed your concern that the returns are lower than FDs and wished to exit the funds and rather shift to equities.

We think such a move would not be prudent at this stage. This article will explain what is happening across all debt income categories (please read our article on dynamic bond category here) and across time frames and why you have every reason to hold on to these funds now. We keep credit funds out of this purview and stick to the most commonly used categories by retail investors. (the categories used are FundsIndia’s scheme classification used before SEBI’s category changes).

Why the fall

The above table tells you that a year ago, income funds looked tempting. Now, among all the categories, the returns are least disrupted in the liquid fund space and most hit in the income fund category. Needless to say, the time frame for investments in liquid funds is the least and income funds the most. In other words, if you held temporary or very short-term investments, you would have been least hurt. The problem arises when you enter with a long-term but cannot hold on in the face of short-term volatility. But let’s understand what happened in this one-year period. The yields of 10-year gilts as well as corporate bonds of varying maturities started moving up, although the RBI did not hike rates.

As yields moved up, the prices of bonds readjust downwards to ensure they deliver the new yields even if they were issued at lower rates. For example, a 5-year AAA-bond may have been issued at say Rs 100 for a coupon rate of 7% a year ago. Now fresh bonds may be coming at 8%. What happens to the 7% bond issued earlier? Its price will fall to ensure that it is also able to yield Rs 8. That means it’s price must fall (as traders sell it) from Rs 100 to Rs 87.5 for it to give a yield of 8% like the new bond. This is what happens in traded securities whether AAA or AA-rated instruments in a rising rate scenario. This is the reason why the returns across all categories fell. The impact is naturally higher when the tenure of the fund (and the underlying papers) is higher and vice versa.

The impact was the least in liquid funds (simply because they buy and hold securities that are not traded and have very short-term papers that are not volatile) and most in income funds. If you wonder, why a category like ultra short-term fund should see decline in returns, it is because of the nature of papers they hold. Ultra short-term funds on an average held a third of their portfolio in AAA and AA+ rated instruments. These are typically traded papers that see volatility. Hence the fluctuation in this category was inevitable although not as high as short-term or income segments. This is also why we do not give ultra short-term if your goal is less than 6 months. We stick to liquid funds.

What is changing

Yields of funds are moving up: That basically means that the newer instruments that debt funds hold will start giving more interest (coupon) that will accrue in the NAV of your fund and up your returns. The table below will tell you how lucrative the yields on the different categories of funds look compared with a year ago.

Average maturity is shrinking: You might then ask, if the numbers look so picture perfect, then why did funds have to deliver lower returns? This is because, funds had to pay a price to readjust. Funds that held lower coupon bonds, saw the price of their bonds fall. But they went ahead and either exited old bonds (where prices would have been declining) or bought some of them at lower price (cost averaging) or bought bonds with higher coupons. In this rejig they would also have bought the bonds with lower residual maturity. This way, they would be less hurt by the price volatility in long-end instruments.

The data above shows how funds have tweaked their average maturity to make the best of the rising rate scenario. This basically means that funds will not take the kind of hit they took a while ago.

How returns bounce back

The graph below is a classic illustration of how returns have bounced back in the past when coupons increase, and average maturities fall in 2011-12. The rise, when it happens, is quite sharp and often adequately makes up for earlier year’s underperformance.

What should you do

It is important to hold debt funds for a tenure that is not less the average maturity of the fund. The average given in the table earlier should roughly be the holding period for funds in that category. This will ensure any fall in performance is made up, as funds readjust to new rate scenario.

In our opinion, unless you have a longer time frame (over 2 years), income funds can continue to be volatile for you. For a duration of less than 2 years, we would prefer ultra short-term and short-term debt funds. For less than a year, stability becomes important and liquid funds offer that. What should you do if you held funds for 2-3 years now? Your annualized returns would then be 7% plus in any accrual fund and therefore not a cause for worry. You should hold it until you need the money.

FundsIndia’s Research team has, to the best of its ability, taken into account various factors – both quantitative measures and qualitative assessments, in an unbiased manner, while choosing the fund(s) mentioned above. However, they carry unknown risks and uncertainties linked to broad markets, as well as analysts’ expectations about future events. They should not, therefore, be the sole basis for investment decisions. To know how to read our weekly fund reviews, please click here.