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Long-term bond fund investors have experienced a fair bit of volatility in recent weeks. Yields of 10-year government bonds recently rose about 30 basis points (bps) to nearly eight per cent, dipping again in the past few days. The volatility has impacted the performance of medium-term and long-term debt funds, with several of these showing negative returns in the past month or so.
The volatility will be particularly unsettling for short-term investors, who'd come in with the specific intention of benefiting from expected interest rate cuts. Experts believe the rise in yields might be a good opportunity for those waiting on the sidelines to enter these funds. "These are good levels to enter from a two to three-year horizon, as interest rates are expected to decline 50-100 bps over the next one to two years," says R Sivakumar, head, fixed income, Axis Mutual Fund.
With Consumer Price Index-based inflation declining to a four-month low of 4.86 per cent, analysts expect the Reserve Bank (RBI) to cut the policy rate by 0.25 per cent in its June monetary review. Wholesale Price Index-based inflation was minus 2.87 per cent for April, the sixth month of a fall. Low inflation and the slowing in industrial activity present a strong case for further rate cuts.
Interest rates and bond prices are inversely proportional. When rates fall, bond prices rise and vice versa. In the past one year, yields in 10-year government papers have fallen to 7.87 per cent from 8.7 per cent, resulting in gains of over 15 per cent for long-term bond funds.
Strategy
There are two kinds of benefits from bond funds - from interest income and capital appreciation. Experts recommend entering these with a horizon of one to three years. 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.
"Assuming interest rates fall between 50 and 75 bps in the next 12-18 months, investors stand to gain 6.5-7 per cent by way of capital gains. Accounting for a coupon accrual of 9.5-10 per cent, investors can make total gains of 15-17 per cent in this period," says Abhiroop Mukherjee, fund manager, fixed income, Motilal Oswal Asset Management.
Investors might be better off entering these funds through systematic investment plans (SIPs), which will help them buy at every rise in yields and average out the costs. "SIP investors will also have to pay a lower exit load than lumpsum investors if they choose to make an early exit," says Mukherjee. Debt funds typically charge an exit load of 50-100 bps if an exit is made in three to six months.
Those not comfortable with the volatility can also opt for systematic transfer plans, from these into diversified equity funds. This would be a good way to nibble into equities, an asset class which has not done too well in recent months. The recent correction has impacted net asset values, which means investors can get more of equity fund units if they buy now.
However, investors should remember that transfers from one fund to another are considered redemption or new purchase for taxation purposes. This means gains from units redeemed before three years will be considered short-term in nature and added to your income, to be taxed in line with the applicable slab.
Investors who are mostly interested in capital gains or those in the 10-20 per cent tax bracket can exit after 18-24 months, if they feel the potential for further rate cuts is minimal. "They can book profits and move into alternative debt products," says Sivakumar. Those in the 30 per cent tax bracket will be better off investing in dynamic bond funds, so they don't have to exit before three years.
Risks
Despite the benign interest rate outlook, there are a few headwinds to look for. For starters, a truant monsoon could lead to higher food inflation. Further, if the US Federal Reserve goes ahead with a rate increase in September, it could lead to a lot of volatility in the bond and currency markets in India. "The resulting volatility might force RBI to hold rates," says Sivakumar.
Next, any spike in global crude oil prices will put a strain on the import bill, and increase inflationary pressures. "If prices shoot above RBI's comfort level of $70 a barrel, there can be a problem," said Sivakumar.
If interest rates do not fall or if the rate cut is not to the extent anticipated, one can expect volatility to increase in these funds. So, investors with a short-term horizon of about a year can consider shifting to short-term bond funds. "These funds have the ability to generate higher returns than fixed maturity plans and bank fixed deposits," said Sivakumar.
