While equity as an asset class, has been struggling to make a mark for more than a year now and investors are seeing their portfolio value getting eroded every now and then; there is another asset class called ‘debt’ that has generated positive and safe returns for investors in the year 2011. Besides domestic concerns, the negatives on global macroeconomic landscape still appear strong; as a result, outlook for equities remains obscure. However, a partial investment in debt oriented mutual funds looks considerable especially after taking into account the positives for the asset class.
In the third quarter mid-review of monetary policy in December 2011, RBI halted further raise in policy rates and signaled the turnaround in the interest rate cycle. This is considered a positive for debt funds as bond prices and interest rates are inversely related. Since the policy announcement came in, the bonds have rallied and the Yield on 10 year G-sec is already down by 75 bps from its peak and is on a further downward spiral.
(Source: CCIL, PersonalFN Research)
Usually the long term income funds and long term gilt funds are the categories of debt funds that benefit the most when the interest rates are on the downward spiral. Though, now it is very unlikely that the RBI will raise the policy rate; the future course of action still remains anybody’s guess as RBI may maintain status quo for a while before it announces a rate cut. Investment horizon and the liquidity requirement are the primary factors that you need to consider before zeroing on the category of a debt mutual fund. However in addition to this, you also need to understand that the direction of interest rates will affect the long term and short term yields differently as the interest rate sensitivity of the longer tenure paper is usually more than the shorter tenure paper.
How the various Categories of debt funds have fared?
|Category ||1 Month ||6 Months ||1 Year ||3 Years ||5 Years ||Std. Dev. ||Sharpe |
|Category Average of Long Term Gilt Funds ||2.1 ||5.3 ||8.2 ||2.9 ||7.8 ||1.56 ||-0.15 |
|I-Sec Li-BEX ||2.9 ||4.6 ||8.1 ||1.4 ||7.4 ||1.72 ||-0.19 |
|Category of Long Term Income Funds ||1.5 ||5.1 ||8.8 ||5.0 ||8.0 ||0.96 ||-0.06 |
|Crisil Composite Bond Fund Index ||1.1 ||4.4 ||7.3 ||5.0 ||6.4 ||0.66 ||-0.12 |
|Category Average of Short Term Gilt Funds ||1.1 ||4.5 ||7.7 ||4.4 ||5.8 ||0.33 ||0.42 |
|I-Sec Mi-BEX ||2.2 ||5.2 ||7.0 ||4.3 ||7.4 ||0.80 ||0.18 |
|Category Average of Short Term Income Funds ||0.9 ||4.7 ||9.3 ||7.0 ||8.1 ||0.28 ||0.81 |
|Crisil Short-Term Bond Fund Index ||0.7 ||4.2 ||7.9 ||6.2 ||7.3 ||0.22 ||0.58 |
(Source: ACE MF, PersonalFN Research; Performance as on January 6, 2012)
Chart above shows that during last 1 year, short term income funds have delivered superior returns in comparison with all other categories. Category average of all schemes classified as short term income funds is 9.3% over the past 1 year. However, Gilt funds that underperformed income funds over the 1 year period have shown swift movement vis-à-vis income funds over the past 1 month period reflecting the positive sentiments among investors after the RBI hinted a pause in rate hikes. Undoubtedly, investment in debt funds look attractive at the moment, but whether one should go with the obvious choice of long term income funds or long term gilts funds remains the debatable question. The performance of these long term debt funds will however depend on the interest rate movement in the short term, medium term and of course long term. Trend in IIP Growth (Y-o-Y)
Direction of interest rates hereon...
The rate cut is contingent upon how two prime factors, Inflation and GDP growth play out. Prime Minister Mr. Manmohan singh has recently expressed his concern about the GDP growth in the current fiscal. He estimates that the GDP growth would be down to 7% from the 8.5% a year ago.
This is also evident from the IIP growth trend which is one of the leading indicators of economic activity in the country. Barring the exception of June 2011 which witnessed an extraordinary surge in IIP growth, industry has been passing through a tepid growth phase since the beginning of this fiscal. This is mainly attributed to the monetary tightening by RBI and partially to the higher commodity prices.
(Source: CSO, PersonalFN Research)
On the other hand, despite the hawkish monetary stance taken by RBI; Inflation has refused to die down and has stayed at elevated levels (above 9%) for successive 12 months. However, finance ministry is hopeful that the inflation would fall down to the level of 7% by March 2012. Trend in Inflation (Y-o-Y)
(Source: Office of the Economic Advisor, PersonalFN Research)
A few more macro-economic indicators......
The government is likely to miss its direct tax collection target this year. The government estimated a growth of 31% in the direct tax collection during the current fiscal. However, an advance tax payment reported by the corporate Inc. in Q3FY12 was up merely by 10% as against 18% growth in the second quarter and 14% growth witnessed in the first quarter. It would be difficult for the government to meet its target. Moreover, aggressive disinvestment target set by the government looks a herculean task. Disinvestment projection for the year 2011-12 has been 40,000 crore but as per the latest data published by Ministry of Disinvestment reveals the mop-up of only 1,144.5 crore. Government will find it difficult to bridge this gap in this fiscal year. On the other hand, government is overrunning its threshold of planned expenditure. As per the finance ministry estimates, fertilizer subsidy alone is expected to shoot up by more than 80% over the budgeted number. Moreover, the food subsidy bill along with the compensation paid to oil upstream and the downstream companies is also likely to be in excess of budgeted allocation. Falling rupee and high crude oil prices may exacerbate the situation further.
For all these reasons government is likely to miss its fiscal deficit target of 4.6% for 2011-12. To finance this deficit, government has been raising money through additional borrowing from the market. Government has already chalked out a plan to raise 52,800 crore in October-March period. Recently it announced to raise another 40,000 crore. This takes the total of additional borrowing to 92,800 crore, over and above the gross borrowing limit of 4.7 lakh core set in the budget.
If the inflation falls to a desirable level and industrial growth fails to pick up in the coming quarters; RBI will then be forced to think about adopting an accommodative monetary stance. Long term income funds and long term gilt funds will generate superior returns during this phase of monetary easing. However investors should gung-ho on them and should be watchful of some possible events that may play the spoilsport.
As mentioned above, RBI is borrowing from the market to finance its budget deficits. This aggressive borrowing program may keep the yields on long term G-secs at elevated levels and rally in bonds may be limited. The real surprise comes from the short term borrowing program announced by the RBI to raise 1.52 lakh crore through Treasury bill auctioning in the Q4 of current fiscal. Higher government borrowing is resulting in hardening of yields on corporate bonds. Credit off-take is cooling and liquidity situation is gradually improving thanks to bond purchase by the RBI, which helped inject liquidity in the system.
We believe that though all the macro-economic indicators point at a possible rate cute, you should consider the potential negatives before going with the obvious choice of long term gilt and long term income funds. Table given below would give you an idea about, under normal circumstances, which category you should ideally go for depending on your investment time horizon.
|Type of Fund ||Time Horizon ||Your liquidity requirement ||Interest rate Risk |
|Liquid Funds ||less than 3 months ||Very High ||Very Low |
|Liquid Plus Funds ||3 to 6 months ||High ||Low |
|Floating Rate Funds ||6 to 12 months ||Medium ||Low |
|Short-term Income Funds ||Strictly 1 year and above ||Medium ||Medium |
|Fixed Maturity Plans of 3 months to 15 months ||Hold till maturity ||Low ||Medium |
|Dynamic Bond / Flexi-Debt Funds ||2 to 3 years ||Low ||Medium-High |
|Pure long-term Income Funds ||3 to 5 years ||Low ||High |
|Gilt Funds ||3 to 10 years ||Very Low ||Very High |
(Source: PersonalFN Research)
We recommend you not to take a call on which end of the yield curve (long or short) would reap the benefits of the possible rate cuts the most. You need to first identify your investment time horizon before making your debt investment call.
Short term investors based on their investment time horizon may choose from the funds suitable for investment period within 1 year. Even though long term funds may show superior performance over a period of next 6 months, you should not invest your short term money in long term debt funds as it may prove risky if you fail to make timely move based on any immediate news flow and the adverse yield movement.
Investors only with a time horizon of 3-5 years may invest in long term gilt and income funds; but do not forget that you may witness some short term volatility in the performance of these long term funds. The impact of this volatility may fade out over a longer period of time. However an investor with a moderate to high risk appetite and investment horizon of 2 year plus would be better off investing in a Dynamic Bond Fund that offers flexibility to invest in papers with various maturity profiles. These funds will have a flexibility to adjust the duration of the portfolio to benefit from the possible change in the interest rate structure.
Your right and strategic move will definitely help you gain from debt market investments.