Don't switch out of debt funds

We have been recommending the long-dated debt fund strategy for some time now. While it has generated handsome returns in the past, conditions are not rosy for investors who got in only in the last three months. Income funds have generated absolute returns of only 0.97% in the last three months while the average longand medium-term gilt fund has lost money .

So what went wrong? After falling for more than 18 months, the 10-year yield remained almost flat the last three months before starting to inch up in the last few days. The 10-year yield is now placed at 7.87%, 22 bps higher than the recent low of 7.65% on 2 February . To find out where the yield is headed, we need to take a look at the factors that contributed to its recent spurt.

First, the spurt in crude prices from its recent lows has raised doubts about the low inflationary situation in India.Brent crude is at $69 per barrel, a more than 40% jump from its January low.However, experts think this spurt is temporary. "What is happening on crude is a technical bounce," says Rajeev Radhakrishnan, Head, Fixed Income, SBI Mutual Fund. This is because there is no reduction in supply by OPEC. "Crude should stabilise between $60 and $70. If prices go above $70, shale producers who shut down production may come back," says Radhakrishnan.

Food inflation is another worrying factor. A below average monsoon is predicted too. However, experts remain unfazed. "The corelation between monsoon and inflation is low," says R. Sivakumar, Head of Fixed Income, Axis Mutual Fund. "Food inflation is due to the increase in minimum support price and the government has made only a very small increase this time," he adds.

The CPI-based inflation, which the RBI uses, is still above 5%. However, the WPI-based inflation is in the negative zone for the last five months and should help bring down the CPI-based inflation.Growth not picking up as expected is another reason for a benign CPI-based inflation. "We are growing well below our potential rates. With enough spare capacity , manufacturer's pricing power is low and this should help inflation to shift lower," says Radhakrishnan. That would mean the RBI's CPI-based inflation target of 6% by January 2016 will be achieved. "Inflation should be close to 5% in the next year," says Sivakumar.

The weakness in the rupee is another factor holding the RBI's hand. The dollar has been appreciating over the last few months due to US rate hike fears and has already reached `64.05. Though RBI wanted a small depreciation in the rupee due to inflation differential, it would not like a sudden crash. Another factor irking RBI is the behaviour of banks, which have not passed on the benefits of the last 50 bps cuts to custom ers. However, the banks have started passing on some benefits. With more banks participating, RBI may restart rate cutting soon. "The next rate cut from RBI may happen before June 30," says Kumar.

The spike in 10-year yield can also be linked to technical factors in the market. RBI is about to issue new 10-year papers, so existing investors are getting out of current ones. "The yield on the existing 10-year paper is high because of the illiquidity premium and the yields on new papers are usually 15 bps lower than the old papers," says Indranil Pan, Economist, Kotak Economic Research. With the FII limit on government securities reached, there is no additional FII inflow here. Any increase in limit will result in fresh bout of buying and bring the yield down again.

Experts are of the view that the 10year yield will come down in a year."The current yield of 7.95% is an aberration and should come down to 7.25% in 5-6 months," says Kumar. Sivakumar and Radhakrishnan agree.

Stick with long duration: Investing in long duration funds is the best strategy to make money from a fall in interest rate. The price of bonds and yield are inversely co-related and bond prices move up when yields go down.Existing investors should stick with long duration funds instead of shifting.They can also consider putting in fresh money into this segment. However, note that the current yield is below 8%."Only investors with long-term holding period and strong views can make money this year," says Pan. "There will be short-term volatilities in long duration funds and instead of selling, they should hold on," says Vidya Bala, Head, Mutual Fund Research, FundsIndia.

Gilt or income: "Income funds are better for retail investors, as gilt funds are for those who have specific views on gilt yields," says Sivakumar. The advantage of income funds is that they can get the benefit of the higher yield in corporate debt papers also. Income fund managers usually invest in corporate debt when the difference between the gilt yields and AAA rated corporate bonds are high and get back to gilt then the yield difference is low. Pure gilt fund investors, who time the gilt yield cycle correctly, may also have to deal with higher taxation. The Indian gilt yield cycles takes 18-24 months. Since the minimum holding period for long-term capital gain for debt funds has been increased to 36 months, active investors who exit before three years will have to pay short-term capital gains tax.

Short-term for stability: Investors who seek stability can go for short-term income funds. Here the returns come through the accrual method. These funds have generated decent returns in the past year. However, short-term rates are expected to fall. A better option are dynamic funds, where the fund manager takes the call on maturity based on his reading of interest rate movements.

Source: http://timesofindia.indiatimes.com/business/india-business/Dont-switch-out-of-debt-funds/articleshow/47410775.cms