Debt funds continue to look attractive in 2017

The funds delivered high returns from 7.5% to as high as 18% last year

After a robust performance of debt funds in 2016, with returns ranging anywhere from 7.5% to as high as 18%, the outlook for debt mutual funds continues to look attractive in 2017, say fund managers. Though the expected returns may not match last year's, investors can expect reasonable returns in higher single digit.

Given the expectations that interest rates will keep moving down this year and inflation will remain benign at or less than 5%, fund managers say there is still steam left in debt funds. Some of the debt funds they recommend include corporate debt funds, duration bond funds and ultra short-term debt funds.

"Long duration funds along with gilt funds should be in a position to post capital gains over 2017. Corporate debt funds should also reap the benefits of credit rating upgrades and credit spread contraction under the load of surplus liquidity, lower borrowing cost and pick up in consumer demand," says Sujoy Das, head of fixed income at Invesco Mutual Fund.

According to him, fiscal consolidation contained net borrowing by the government over FY18, and a structural re-adjustment of the inflation along with tighter real rates targeted by RBI opens up room for repo rate reduction. "Expect interest rates to keep moving lower over 2017. Surplus liquidity collected as deposits by the banks during demonetization drive is expected to get unwound over the months and get redeployed into bonds, gilts, corporate advances and term loans by the banks," he adds.

In a statement, the fixed income team of Franklin Templeton Mutual Fund, said: "Although the government bond yields have come down significantly in the last few months, we believe that slowdown in growth, benign inflation coupled with fiscal prudence and lower government borrowing could provide some headroom to the RBI for one interest rate cut. Hence, investors (who can withstand volatility) can consider duration bond/gilt funds. Further, low capacity utilisation leading to low credit offtake/supply could augur well for spread compression in the sub-AAA segment. Hence we continue to remain positive on corporate bond and accrual strategies."

Fund managers say that the quantum of drop in repo rate will be a function of how low the inflation drops and for how long it stays at those levels.

Lakshmi Iyer, chief investment officer (Fixed Income), says: "The net borrowing levels are largely contained and the post-remonetisation liquidity will also gradually find its way back into the banking system. All these are significant markers for improved interest rate conditions and RBI may find headroom to deliver a 25-50 basis points rate cut from current levels. However, the year is also scheduled for an array of domestic and international political events that may have uncertain impact on markets."

According to her, the accrual/credit funds at current yield levels present an attractive risk-reward trade-off and suggest a higher allocation to them. "Investors with one-year horizon should consider short-term bond funds with a marginal top up of actively managed duration funds. Pre-existing duration investors may continue to hold their duration investments to allow for the entire rate cycle to play-off and allow the potential MTM gains to accumulate. Investors with 3 to 6 months horizon can also look at investing in well managed ultra-short-term-debt funds to make marginal gains on their parked investments for the given tenure," she further explained.

Debt funds, which contribute nearly 65-70% of the mutual fund sector's overall assets under management (AUM), have given quite a good returns to investors over the last three years. Last year, though, was quite robust. The range of returns in last three years from debt category of funds has been 8-15%. Credit opportunities funds, dynamic bond funds and gilt funds have returned double-digit performance for investors. This is much higher than what plain-vanilla bank deposits or recurring deposits would have offered during the same time frame.