Keeping The Interest

Bond funds will not be able to replicate their past performance, but they will provide stable returns

Stellar returns posted by bond funds on the back drop of falling interest rates made them compelling investment options for most investors. And with a rash of bad news sending the equity markets into a tailspin, investors flocked to debt funds.

Furthermore, falling interest rates and increased demand for quality paper pushed bond prices higher. As a result, bond funds have generated impressive returns. The average one year return of the bond fund category stands at a healthy 13.50 per cent. However, the returns are far below the returns generated by debt funds a year ago. Debt funds posted a return of around 16 per cent.

But going forward, investors should keep in mind that even these returns are not sustainable. The average returns generated by debt funds will always be closer to the current yield on fixed-income securities.

Says K Ramgopal, chief investment officer, fixed income, IL&FS Mutual Fund, "Looking at short-term returns for securities with longer term maturities can be very misleading. Taking such a view is best suited for traders but for retail and long-term investors, it only gives a distorted picture. Investors have to keep in mind that returns from debt funds will always closely track the current yield on securities."

Gains from trading opportunities and capital appreciation, as a result of interest rate cuts, can add a couple of basis points to your fund return. The current yield on the 10-year benchmark government security is around 7.10 per cent.

At present, a 5-year AAA corporate paper trades at abysmally low yields of 6.98 per cent, the yield on a 5-year gilt is at 6.25 per cent. At the start of March 2002, the yield on a quality AAA, 5-year corporate paper was 8.9 per cent, which dropped to 8.5 per cent in April.

Since the yields have been steadily declining, it will be unrealistic to expect funds to sustain the returns generated in the past. Binay Chandgothia, head, fixed income, IDBI Principal mutual fund, says, "If you are investing in debt fund now, all things considered, you can expect to earn returns in the range of 7.50 to 9 per cent."

While the returns are getting lower, the risks associated with these funds are becoming higher. Apart from the credit risk and interest rate risk which are inherent in fixed-income securities, the uncertainty on the impact of the delayed monsoon on the economy and on the political front have increased the overall risk. But they are still less volatile than equities and the returns are more stable in comparison.

Most fund managers are expecting 25-50 basis points cut in the bank rate in the forthcoming credit policy, anticipating some capital appreciation, funds have increased the average maturity of the portfolio.

For instance, Sun F& C have increased from 3.3 years in May 2002 to 5 years. Similarly IDBI Principal has also increased the average maturity of its bond fund.

But as an investor, you have to keep in mind though the bank rate cut will result in some gains through capital appreciation, the incremental returns from then on will belower as the funds will be investing in lower yielding securities. So the overall return on the bond portfolio will dip lower.

After losing heavily in May, funds reduced their exposure their exposure to government securities. However, on expectations of a rate cut and interest rates likely to maintain a downward bias, funds have hiked their exposure to government securities. For instance, IDBI Principal Mutual Fund increased its exposure to government securities from 30 per cent levels to over 40 per cent since May this year.

Given the movement in government securities have been rangebound, there has been great demand for quality corporate paper. So the yields of corporate bonds are declining faster than the yields on government securities.

For instance, the yields on corporate bonds have fallen 80 basis in the past two months. Against this, yields on government securities with similar maturity have declined by just 40 basis points during the same period.

As a result, spreads between government securities and corporate bonds have been compressed further. In fact, the current spread between the two securities stands at just 70 basis points. The spread between AA and AAA bonds have narrowed down to around 30 basis points.

A couple of months back when the spreads between AAA and AA bonds were lucrative, many funds took on some credit risk and hiked their exposure to AA bonds. Given the fact that the spread story no longer exists, most funds are now switching back to good quality corporate paper.

Even in the backdrop of lower returns, given that equity markets still in doldrums and other investment avenues being limited, debt funds still look attractive. If you are on the lookout for stable returns and are content with the returns or with the slightly more than prevailing yield on gilts, then you can invest in these funds with a one-year perspective.

Among the bond fund, we recommend JM Income fund which has always been in the top three funds in this category. Active portfolio management and aggressive bets on interest rates has helped the fund sustain its position.

We also like HDFC Income Plan which has been a steady performer. With a focus on credit quality, the fund has little exposure to lower rated securities. Ideal for investors looking for steady returns.

Templeton India Income Builder Account too, by making aggressive duration bets, has managed to outperform its peers. The fund is not averse to taking on additional credit risk to rope in extra returns. With a longer portfolio duration and a well-diversified portfolio, the fund should benefit for any possible rate cut.