The sharp fall in returns from bond funds over the last three months has cast doubts over their reputation as investment options that provide steady inflation beating returns at a relatively lower volatility. Since 2008, bond funds had anchored investor portfolios suffering from high volatility and low returns in stocks.
A plethora of products, including corporate bond funds, high yield accrual debt funds and closed-ended debt hybrid funds such as capital protection-oriented funds, were launched to cater to the evolving needs of investors. The result was that allocation to debt funds gradually increased in investor portfolios over the years.
It is precisely due to this reason that the recent bout of volatility has hit hard, raising questions whether the party is over for debt funds. The answer depends on how you look at it.
A section of the crowd ‘thinks’ that the current tight liquidity and high interest rate phase shall continue longer and that the pain (in terms of rise in bond yields) is about to worsen. We call this reacting to short-term price movements. People who do so are abundant in all markets, be it bonds or stocks or any other market.
Then, there are others who believe in the theory of mean reversion and believe that this phase is temporary. Such people are rare. They see such phase as a temporary imbalance in the market, which will correct itself. All markets have an inbuilt self-correcting mechanism that enables them to regain equilibrium once stretched beyond a limit. Optimists would say that high interest rates during the last two months will weaken growth (besides bringing down inflation) and, hence, open us up for lower interest rates in future. Bond fund investors tend to gain when interest rates fall.
The power of holding on and not succumbing to emotions: That the current phase is ‘unsustainable’ is evident from the sharp fall in 10-year g-sec yields from 9.47% to 8.3% in two days (the rise from 8.3% to 9.47% incidentally took more than 4 days) once the RBI launched its own version of Operation Twist, i.e., increasing supply of short-term bonds and reducing supply of long-term bonds (original version belonged to the US Fed) on August 21, 2013.
This shows that the recovery can be faster than the fall, if you hold on. If somebody had booked losses and shifted to ‘safety’ on Aug 19, 2013, it would have taken much longer to recover the losses. Liquid funds or bank deposits, at their prevailing yields will need approximately four months to recover a notional loss of, say, 3%, something that was done precisely in two days by bond funds. Periods like the one seen since July 15, 2013, are rare. The last time it happened was in 1998 during the Asian currency crisis and lasted for about two months. For the record, in the last six years since May 2007, 10-year g-sec yields have traded above the 8.5% mark for only 9.2% of the time. And in each case when they went above 8.5%, yields fell back below the level within three months from the date of such breach.
What should an investor do?
There would be two kinds of investors at present — those who are already invested in debt funds (majority I believe) and those who are on sidelines and holding cash (a rarity in my opinion). Those who are already invested must hold on, unless you really need the money in the next three months. As shown above, this can be your shortest, though, maybe, more painful, way to recovery.
For onlookers, there is a handsome opportunity in both accrual as well as duration plays. AAA rated bond yields are in double digits, look pretty attractive, and should head lower in the medium term.
However, income fund is not the only manner in which you can benefit from the opportunity. Depending upon your target investment horizon, you can also choose short-term debt funds, high yield accrual funds, corporate bond funds or dynamic bond funds. Most of these funds currently carry double-digit yields (high accrual income) with low durations reducing their sensitivity to interest rate movements.
Capital protection-oriented funds and other closed-ended debt focused hybrid funds that invest 70-80% of their portfolios in bonds have simply turned more attractive. With yields on AAA bonds ruling in double digits, their return potential has increased significantly without a commensurate rise in risk. The debt fund party is thus far from over with the next leg about to begin.
n The writer is vice-chairman & managing director, Bajaj Capital