Photo: iStock
Photo: iStock

Duration risk put debt funds on a slow track in 2017

For market-linked bonds, it was the lack of duration-led return opportunities that underlined the trend in 2017

Interest rates went down in 2017 across the board. Returns from small savings schemes, mutual funds and fixed deposits were lower than in the previous years. A declining interest rate regime in the country, due to falling inflation, also saw the repo rate—the rate at which the central bank lends to commercial banks—being gradually cut to 6% from a high of 8% in January 2014. The repo rate had touched a high of 9% in July 2008. This downward trend, which had affected market yields sharply in 2016, took a pause in 2017 with only one cut of 0.25 basis points. One basis point is one-hundredth of a percentage point.

As a result, bond yields in the secondary market, too, did not fall; instead they moved up in 2017. Bond prices rise when interest rates fall, and vice versa.

Duration of a bond measures its price sensitivity to change in rates. In a falling rate environment, bond portfolios register capital gains as prices move up. Now that the downward rate cycle seems to be coming to an end, this opportunity for capital gains is also limited. 

For market-linked bonds, it was this lack of duration-led return opportunities that underlined the trend in 2017.

Duration-risk

Returns from secondary market selling, bond funds and dynamic income funds all took a knock as the downward trend in interest rates paused. According to R. Sivakumar, head-fixed income, Axis Asset Management Co. Ltd: “For now, the rate cycle has bottomed, which is reflected in the bond market given that benchmark yields are down roughly 1% over the last 1 year. There has been one rate cut but RBI’s tone is hawkish. Moreover, liquidity is in balance after seeing a surge after demonetization. Lastly, there is expectation that fiscal deficit could be higher than the target for the next 1-2 years. These factors put together have meant that all yields have risen through this year, and as of now, there is no structural trend to look forward to." 

The risks may not be fully priced in yet, but there is no apparent trigger for rates to fall either, suggesting a more range-bound activity for now. Moreover, upside risk to inflation, as cited by market watchers and economists, means that a possibility of rates remaining at current levels or even moving higher soon cannot be ruled out. 

Lakshmi Iyer, head-fixed income and products, Kotak Asset Management Co. Ltd, said, “For 2018, inflation is not a big concern. If inflation remains low, there could be one more rate cut but that doesn’t justify an aggressive allocation to duration. A bigger concern is the fiscal deficit, and with limits full for FIIs (foreign institutional investors), who will buy the excess supply in the market. This will keep yields in check." 

Bond funds with high duration suffered and gave average category annualized returns of about 5%. 

Move to accrual income

With returns from duration strategy shrinking, investors had to seek other securities and funds to make up for the gap.

At present, the 8% Government of India bond is probably the highest-return safe security. But in this, money remains locked-in for 6 years and the interest is subject to tax at your marginal rate of income tax. Returns from other government savings schemes and even the Public Provident Fund (PPF) is in the range of 7.5-7.8%. With annual return of 6.5-7.5%, bank fixed deposits offer even lower post-tax earnings. 

As a result, investors have started shifting to more stable-return short-term income funds and even low-risk blended equity funds. Financial advisers are inclined to help investors either lower their returns expectations from the fixed income allocation or add a bit more risk and shift to blended equity products where they are comfortable with additional risk. Read more here.

“It’s best to have some allocation to short-term income funds. They are the least affected by rate cycles and also help balance risk," said Deepali Sen, founder and director, Srujan Financial Adviser, LLP.  

After double-digit returns in 2016 for some long-term income funds and dynamic bond funds, investors had to be content with much lower single-digit performance from these funds. Even for long-term bonds like tax-free bonds and corporate bonds, the market yield has fallen, making the investment less lucrative in the secondary market.

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