Fixed income or debt funds are the go-to asset class, when linear secular income is the goal. The years in which the equity markets have delivered single digit return, debt funds of mutual fund schemes have delivered double digits. However, the year 2017 was tepid in terms of the return generated across debt funds.
Falling interest rates
In fixed income, rates of fixed deposit have been declining. This is worrying investors who pre-dominantly invest in them. The re-investment opportunity at the previous rates or higher rates is no longer there with interest rates falling. With RBI adopting the policy of controlling inflation and status quo on rate hike being maintained, investors in fixed income had a forgetful 2017. And what about the accrual and duration schemes of the mutual funds? The 10 year bond yield has displayed a volatile range in 2017. If one is expecting the rates to be still, any volatility effects the duration scheme. A move towards the north, lowers the yield to the existing investors and reduces the return to the investor, not considering the risk of capital depreciation. The average return in a dynamic bond fund, which had built up a sizeable assets under management (AUM) in the past years was in the region of 4%. Considering the tax on the income and if you are in the 30% bracket, the returns hardly met the inflation. When you consider ‘income’funds, the returns have been marginally higher in the range of 5-5.32%. So what went wrong? The pause in rate cuts did not help the returns coupled with volatility in the bond market. However, the credit opportunities fund as a category generated a return close to 8%. But in a credit opportunities fund, one runs the risk of credit default and a portfolio of AA or higher rated papers gives necessary comfort. One should not chase returns through the debt funds. In debt funds, it is important to have safety of capital and assurance of secular income.
Balanced funds remain popular
Keeping it simple did help when investing in debt funds. Investments in the category of liquid funds, short term and ultra-short term categories have helped generate a return of close to 6.5%. In a volatile bond market scenario, it is recommended to invest in papers which will have lower volatility and predictability of returns In this scenario, liquid funds category fit to a tee. Majority of the credit paper being in the duration of 0-91 days and a few papers up to 180 days, lowers the volatility risk. Hybrid funds with a mixture of debt and equity or balanced funds was the new favourite among the investors. With the equity portion of the portfolio generating a double-digit return and the debt portion providing the stability in returns, investors only poured more into the balanced fund schemes.
Moreover, distribution of regular dividends, coupled with positive taxation bias, provided a secular cash flow linearly to the investors. Any upward movement in interest rates will have a short term impact on the existing debt portfolio. Investment in debt funds are not to be considered for generating alpha. One must look at credit risk, default risk, and more importantly, the re-investment risk before investing in debt products. What should be the strategy for 2018? Interest rates could go north in the first or second quarter if RBI re-visits the monetary policy. Again, the decisions by the US Fed could trigger a rally in the bond market. All of these are mere conjecture and one needs to take an informed decision based on each investor’s unique needs. When you need to park the funds for a duration, even up to a year, consider liquid funds. Dynamic bond and income funds need to be considered only post the rate hike, if any.
The writer is founder and managing partner, BellWether Advisors LLP