RBI's stance might limit gains in duration funds

Those with a horizon of less than 18-24 months could consider shifting to short-term bond funds

The Reserve Bank of India (RBI) cut the repo rate by 25 basis points (bps) to 7.25 per cent on Tuesday. With the cuts in January and March, the apex bank has reduced the rate by 75 bps this year.

While the rate cut is good news for existing long-term bond fund investors, those planning to enter these funds might be in a bind. The central bank has indicated it is in favour of a long pause now. Several market participants expect no further cuts this year.

This could be bad news for those planning to enter these funds solely to benefit from capital gains. “Investors should not park their money in duration funds if the investment horizon is less than 18-24 months. Instead, they could invest in ultra short-term or short-term bond funds, which are less volatile,” says Dwijendra Srivastava, chief investment offer (fixed income), Sundaram MF. At 8.5-9 per cent, short-term bond funds are likely to generate higher returns than fixed maturity plans and bank fixed deposits through the next year.



But with a rise of about 10 basis points rise in yields on the 10-year government paper on Tuesday, those with a three-year horizon could enter at this time. Assuming another 50-bps rate cut through the next two years, one could hope to make annualised returns of seven-nine per cent in duration funds. Staying invested for three years will be beneficial, especially for those in the 30 per cent tax bracket, as the gains will be considered long-term and taxed at 20 per cent, with indexation.

Now, systematic investment plans (SIPs) could be a good entry strategy, as investors could buy at every rise in yields and average-out costs if volatility persists. “SIP investors will have to pay a lower exit load than lump-sum investors in case they choose to make an early exit,” says Abhiroop Mukherjee, fund manager (fixed income), Motilal Oswal Asset Management. Typically, debt funds charge an exit load of 50-100 bps in case of an exit within three-six months.

 
Existing investors could continue to hold duration funds, but don’t expect any short-term returns for now. “A rate cut pause could mean the upside is capped for investors this year. But since the yields on 10-year government bonds are likely to remain stable, the downside is limited, too,” says Mukherjee. “For the major part of last year, inflation was lower than RBI’s estimates. So, if the monsoon situation does not turn out to be as bad as anticipated, we could see one or even two more rate cuts this year,” says Mahendra Jajoo, an independent analyst.

However, investors should not discount external headwinds. If the US Federal reserve opts for a rate increase later this year or if global crude oil prices rise above RBI’s comfort level of $70 a barrel, the central bank might continue to hold rates.

Interest rates and bond prices are inversely proportional — when interest rates fall, bond prices rise and vice versa. In the past year, yields on 10-year government papers have fallen to 7.7 per cent from 8.6 per cent, resulting in gains of about 15 per cent for long-term bond funds.