'Duration funds less attractive, stable accrual debt funds better placed'

Bond yields in India have been under pressure since the last few days as yields globally have started moving up with US 10-year up by 15bps in last one week from 4.1% to 4.25% as expectation of one more rate hike by US Fed rate rises.  India 10-year yield is currently in the vicinity of 7.25%, up by around 5-7bps. 

"In general over last 1-2 years, Indian bond market has outperformed US  markets as reflected in the narrowing of the US-India yield spread (spread has reduced to around 300bps from an average of around 500-600bps).. In our baseline scenario, rate cuts if any will be shallow and linked to downside surprises on growth . The current spread of 75 bps of 10-year G-sec yield over repo rate is at the lower end of the historical range. These spreads can further shift lower only when the market starts factoring in rate cuts," said brokerage ICICI Securities in a note. 

 

 Since a rate cut by the RBI is not expected in the near term, duration funds or G-Sec funds are less attractive compared to other category of funds.

In such a scenario, stable accrual debt funds are better placed now for core portfolio allocation, according to ICICI Securities. 

Debt funds provide scope for higher returns if interest rates fall and vice versa. Bond prices rise when yields fall (positive for debt fund returns) and bond prices fall when yields rise (negative for debt fund returns).

Here are the category wise top picks by ICICI Direct for debt funds 

Understanding debt funds

Debt mutual funds invest in fixed-income securities such as corporate bonds, Government securities, commercial papers, etc. These securities have a pre-defined maturity date and interest rate. However, the cumulative returns from debt mutual funds are not fixed. The returns come from two streams: the interest received on the securities and any capital gains/losses from a change in interest rates. 

The price and yield of any bond are inversely proportional to each other. So, the yields fall when the price goes up, and vice versa.

 Ajinkya Kulkarni, Co-Founder and CEO, Wint Wealth explains this with an example.

If an investor buys a bond of Rs 1000 at 9% per annum interest and three years of maturity, it will fetch Rs 90 per year in interest income if the interest rates increase, bonds with higher yields will be in the market. Thus, the earlier bond the investor holds will go down in price. Let us say it sells at Rs 900. So, the effective yield is Rs 90/900= 10%. In the opposite case, if the interest rates go down, the bond price will increase, and the yield will reduce. The fund manager can vary the duration of the securities held in a debt fund to maximize the gains across different rate cycles. 

Debt funds offer higher returns in a falling interest rate scenario.  As a rule of thumb, if the interest rates are falling or eexpected to fall, short- to long-term bond and gilt funds would bode well. But if interest rates remain flat or move upwards, stick to liquid funds; they are safer than the rest of the debt schemes, if not the safest of all financial instruments, and they would still earn you more than your savings bank account.

Point to note: Capital gains from new investments in Debt Funds are now taxed as per your individual slab rates irrespective of the holding period. Previously, Debt Funds had a taxation advantage over FDs (gains from debt funds held for 3+ years were taxed at 20% post indexation).

What is the difference between accrual funds and duration funds?

Accrual and duration-based debt mutual funds differ in terms of the strategies fund managers adopt. 

 Duration based strategy invest in long-term bonds and benefit from the interest rates fall. They earn from capital appreciation along with the coupon of the bond. But, these funds are exposed to interest rate risk and these funds can bear capital losses, if the interest rates move up. Generally, when the interest rates are going down, the duration fund manager chooses a relatively high duration, so as to, maximize Capital Gains from the rising bond prices.

Duration based funds are only good when interest rates decline and needs close monitoring.

 Gilt funds and long-term debt funds offer higher returns when interest rates start falling because of the inverse relatiuonship between bond yields and prices. However, with the RBI holding rates, it is uncertain when the RBI will start cutting interest rates.

Accrual funds are low risk investments, and typically invest in short to medium maturity plans. As per Cleartax, they take credit risk and invest in lower-rated securities for the sake of generating a higher yield. The main aim of accrual funds is to earn interest income in terms of coupon offered by bonds. These funds adopt buy and hold strategy and, and hold the assets till maturity. They also focus on generating better returns compared to bank FDs.

"Accrual Funds are an ideal investment option for investors who have a viewpoint about the interest rate movements. Ultra short term bond Funds, FMPs, and Short Term Bond Funds follow this strategy. If an investor needs a steady return from his debt Portfolio and is not ready to take higher risks, should ideally invest in Accrual based funds. These funds are suitable for investors who want to earn desire stable returns. It is advised to invest in Accrual Funds for least a 1-3-year horizon," according to Fincash, an online investing platform. 

Long duration funds invest a large portion (around 65%) of their total corpus in fixed income securities. These may be Government bonds, corporate bonds, Treasury Bills, and bonds issued by banks. The average maturity of long-duration funds is more than 36 months. 

Gilt funds invest in high-rated securities only, they are generally government securities. These may be securities of central and state governments. These securities have a long and medium maturity period accompanied by low credit risk. Low credit risk can be attributed to the fact that the government rarely defaults on its loans. Gilt Funds are ideal for risk-averse investors who are expecting a fixed income from their investments.