Long-term bond funds are poised to deliver good returns this year on the back of softening interest rates and present themselves as an attractive investment option, says credit rating agency Crisil.
Investors in such funds are likely to benefit when the interest rates fall as returns in long-term bonds increase sharply in response to the declines in interest rate. Debt funds (including gilt funds) have already witnessed inflows of more than Rs 5,000 crore in December 2008 alone.
A review of the last quarter of 2008 revealed a better performance by debt funds. The Crisil MF-Gilt Index saw gilt funds giving a return of 21 per cent and Crisil Fund-dX saw long-term bond funds delivering over 8 per cent return in October and December 2008.
According to S Venkataraman, senior director at Crisil, corporate bond yields are likely to soften further in 2009. “In the current environment of declining inflation and subdued industrial growth, we expect the soft interest rate regime to continue and therefore, corporate bond yields are likely to soften further,” he said.
Explaining the correlation of lower interest rates, bond yields and debt fund performance, Krishnan Sitaraman, head of Crisil FundServices, said, “When interest rates decline, bond yields also decline. As a result, bonds already issued would start trading at higher prices so that their yields match the current yields in the market. The extent of this inverse relationship is more accentuated in the case of long-term debt. Therefore, portfolios of long-term bond funds and gilt funds that are predominantly invested in the long-term corporate debt and gilts will see a faster rise in net asset values, translating into superior returns.”
Crisil says that this year will resembles the scenario noticed during 2001-03, when post the dotcom bust, equity markets underperformed significantly. During this period, debt funds became more attractive for investment purposes as interest rates were cut by RBI to fuel economic growth.
“The positive outlook for debt funds notwithstanding, it is important for debt fund investors to be aware of other risks such as the credit quality of the bond fund portfolio. The extent to which an investor stays invested in a debt fund and timing of the investment would also have a bearing on returns. This is because if interest rates start reversing at some point, debt funds would start giving lower returns. This calls for a close monitoring of the interest rate trends in the economy and credit quality ratings of the funds,” adds Krishnan.