Longer-horizon debt funds bounce back in 2023 as bond yields soften

Timely calls on duration help fund managers make the most of interest rate volatility

Actively managed debt funds with the flexibility to go long on duration made a strong comeback on the returns chart in 2023, thanks to softening bond yields. The average one-year returns of floater, long-duration, gilt, and dynamic bond funds, which ranged between 2.3 per cent and 4.5 per cent at the end of 2022, now stand at over 7.2 per cent, with some schemes delivering over 8.5 per cent, according to data from Value Research.

Debt fund returns are inversely related to yields of underlying investments, meaning a decline in yields is positive for funds. Also, the longer the duration of debt papers in the portfolio, the larger the gain.

Ten-year government bond yields were relatively volatile in 2023, moving in the range of 6.96–7.43 per cent. At present, they stand at 7.19 per cent, according to data from Bloomberg.

“Fund managers who raised the duration at the right time benefited from the softening in yields. Although the decline is on the lower side, it is good enough to boost returns of funds with higher duration,” said Lakshmi Iyer, chief executive officer-investment and strategy, Kotak Alternate Asset Managers.

“The duration of a portfolio works as a multiplier. Hence, fund managers who raised their portfolio duration at the right time benefited from the decline in yields,” said Joydeep Sen, author and corporate trainer (financial markets).

Softening yields and active duration calls were not the only factors behind the improved performance of gilt funds, especially schemes that have delivered above-par performance.

“In 2023, investing in floating-rate bonds helped the fund perform well. This approach worked well for us because, in this rate cycle, where the Reserve Bank of India (RBI) moved from 4 per cent to 6.5 per cent, these bonds delivered good returns to investors and emerged as a major differentiator for us,” said Anuj Tagra, who manages the gilt fund at ICICI Prudential Mutual Fund (MF). The scheme has delivered 8.6 per cent in the one-year period.

At the end of November, the scheme had close to 40 per cent exposure to floating-rate government bonds.

Kotak Gilt Fund, which has also delivered over 8 per cent return, had 28 per cent of its portfolio invested in these papers as of November 30, according to Value Research data.

Floating-rate bonds do not have a fixed interest rate like other regular bonds. The rate is linked to a benchmark and keeps changing depending on the trend in the debt market.

Floater funds, which predominantly invest in floating-rate bonds, have also shown a sharp improvement in performance. On average, these schemes have delivered 7.7 per cent in the one-year period.

Sandeep Yadav, head of fixed income at DSP MF, who also co-manages the DSP Strategic Bond Fund, mentioned that the scheme successfully navigated interest-rate volatility by making timely interest rate calls. This included taking on additional risks when yields fell and reducing risks during uncertain times. The fund has delivered an 8.1 per cent return in the one-year period.

Fund managers and analysts expect longer-horizon debt funds to deliver even better performance next year as rate-cut hopes build up and a likely surge in demand owing to JP Morgan bond index inclusion.

“There is a tailwind of foreign institutional investor (FII) buying in the Indian debt markets due to bond fund inclusion. Markets are expected to start discounting rate cuts by the RBI in the coming months. Liquidity tightness in the system is expected to ease due to government spending and RBI intervention in the rupee market to sterilise dollar inflows due to FII buying. Next year is expected to be good for bond markets due to higher accrual and capital appreciation,” said Murthy Nagarajan, head-fixed income, Tata Asset Management.