The Reserve Bank of India (RBI) on Tuesday steered clear of a rate cut, but market remains hopeful that interest rates are on the way down. In a falling rate scenario, long duration income funds are likely to deliver better returns over the next 12-18 months, say fund managers.
On January 15, The RBI had cut repo rates by 25 basis points. That, coupled with falling crude prices and lower inflation lead fund managers to believe that 2015 may see policy rates cut by over 75 bps. In such scenario, long term debt products like income funds and gilt funds can deliver better returns for investors. Some income schemes have already given returns in the range of 16-20% in the last one year.
The 10-year benchmark government securities (G-Sec) yields, currently trading at around 7.7%, may come down further to 7.25% in the next six-nine months, resulting in a huge advantage to long term bond funds. Also, yields on 10-year AAA corporate bond is somewhere near 8.38%, giving income schemes an advantage over pure gilt funds.
“Unlike gilt funds, income funds can invest in government as well as corporate bonds across maturities. This is single biggest advantage of income schemes as yields are higher in 10-year AAA rated paper of corporate compared to government securities (G-Sec) yields and if the duration is suitably managed they can give better returns than gilt funds over 2-3 year time frame” said a fixed income head from a top fund house.
The prices of fixed income securities are governed by interest rates prevailing in the markets. Interest rates and price of fixed income securities are inversely proportional. When interest rates decline, the prices of fixed income securities increase. Similarly, when there is hike in interest rates, the prices of fixed income securities come down.
Dwijendra Srivastava, CIO-Debt at Sundaram Mutual Fund says, “The spreads between 10-year government and corporate paper is approximately 40-50 bps and there has been good interest in corporate bonds. Currently we have 20% exposure in corporate bonds which can be increased going forward given the interest rate scenario. Investors stand to gain from investing in longer duration income schemes.”
However market participants also caution that such funds are directly aligned with benchmark interest rates and may see significant volatility given the duration of products.