Time to look at long-term bond funds

Time to look at long-term bond funds

With equity markets and equity mutual fund (MF) schemes taking a breather from the global turmoil that impacted India in the past month, the action is slowly turning to the debt market. Long-term bond funds are gearing up for falling interest rates in India. Debt funds do well when interest rates fall as there is an inverse relationship between the two.

Long-term bond funds have increased their duration (expressed in years; the duration tells you how much your debt fund would get affected if interest rates—your bond fund’s yield—were to move up or down by 1%) and their average maturity or the number of years left for your debt fund’s existing scrips to mature (see graph). Already, fund houses are offering potentially-attractive fixed maturity plans (FMPs), while six-month short-term bond fund returns have shot up to about 7-8% per annum during the past six months.

We suggest you take a look at long-term bond funds, even if selectively. Here’s why.

Falling interest rates

Many fund managers believe that interest rates will soon start falling largely because inflation is expected to stabilize. At present, inflation is at 9.22% (as on 31 July). Though it has marginally dropped this year (9.47% at the start of 2011), inflation is still up from where it was at the start of 2010 (8.68%).

Also See

•Short-term Funds Are Set For An Encore (PDF)

•Long-term Bond Funds Have Increased Their Maturity Periods (PDF)

One of the main reasons why fund managers claim inflation will fall is a potential drop in global oil prices. Market estimates suggest that almost 70% of India’s oil requirements are met through imports. Rising oil prices globally have affected India’s imports; in simple words, petrol for our cars and other vehicles has become costlier by the day. Higher oil prices also lead to higher food prices because it increases the cost of transportation of food items. To combat rising inflation, the Reserve Bank of India (RBI) has increased the key interest rate (repo rate or the rate at which banks borrow from RBI) 10 times since April 2010.

But that is largely expected to change. “Crude oil prices globally are expected to correct, especially since the crisis in Libya is expected to be resolved sooner than later. Once Libya starts to manufacture oil, the supply of oil will increase that is supposed to bring down global oil prices," says Sandip Sabharwal, head of portfolio management services, Prabhudas Lilladher Pvt. Ltd. Add a normal monsoon to that and Sabharwal feels that food inflation (food prices) should also come down slightly.

A slowing growth can also be another reason why interest rates could soon start falling. The growth in credit offtake of companies from the banking system have been moving down over the past one year. In simple words, companies have been borrowing less. As per data available from RBI, growth in credit (year-on-year) has dropped to 18.5% as on 29 July compared with 20.7% as on 17 June and 24% at the start of the year.

On the contrary, deposits have grown by 17.3% as on 29 July compared with 16.46% at the turn of the year. “A significant chunk of credit offtake could be because companies are borrowing for their working capital (daily requirement) needs and not long-term expansion or growth. There is a lot of concern about a lot of developed countries, especially after the recent downgrade of the US and the continued turbulence in the euro zone, which could put downward pressure on commodity prices. Growth is expected to slow down globally which could positively impact the domestic inflation trajectory," says Rajeev Radhakrishnan, head (debt funds), SBI Funds Management Ltd. Radhakrishnan feels that although RBI may not cut interest rates in the “immediate future", it may go for “an elongated pause".

“If companies go slow in their activities and there is little demand for long-term money for growth and expansion, then the banks would invest their surplus money, which would otherwise be lent, in long-term bonds and government securities, thus bringing down interest rates," says Ganti N. Murthy, head (fixed income), Peerless Funds Management Co. Ltd.

In other words, falling interest rates will be beneficial to bond funds, especially long-term bond funds.

The concerns

Apart from inflation that may take its time to come down, fund managers are watching India’s fiscal deficit situation. Put it in simple terms, a fiscal deficit is the gap between the government’s income and expenditure.

“Since the government incurs a bill in food and fertilizer subsidies, we need to keep a watch on how much it spends and earns this year. Disinvestment has not happened to a large extent, so the government is not going to earn much here as was previously expected," says Alok Singh, head (fixed income), BNP Paribas Asset Management (India) Ltd. What Singh means is that if the government spends more than it earns through its usual means, it will issue government bonds to raise money. The additional supply of government securities in the market will bring down the bond prices and push the yields up.

Though inflation is expected to come down, there is no one answer on how soon it will drop. “The non-food manufacturing inflation is above the comfort zone of RBI and hence we feel that the central bank may wait for this number to come down before pausing," says Vikrant Mehta, head (fixed income), AIG Global Asset Management Co. (India) Pvt. Ltd. Same is the case for oil prices, Mehta adds, and it will eventually come down.

Why long-term bond funds make sense?

Although it is anybody’s guess when interest rates will actually begin to fall, it makes sense to take a partial exposure to long-term bond funds now. Debt funds managers have started advising investors to put money in them already.

With a large chunk of fund managers and bond market experts expecting that interest rates may not go much higher than the present levels, long-term bond funds have started taking exposure to debt scrips with longer tenors.

Dynamic debt schemes that have the flexibility to invest in scrips across maturity periods depending on the fund manager’s perception of where the interest rates can go have increased their average maturity periods. For instance, dynamic debt schemes schemes of fund houses, including Reliance Capital AMC, SBI Funds Management and BNP Paribas AMC, have increased their average maturity periods to three to seven years, up from just about 10 months to a year of maturity, prevalent in May 2011.

Remember that though long-term bond funds have a duration up to three to even four years, that doesn’t mean you should stay invested in them for long. Take strategic positions in them, instead. “Investors should avoid staying invested in them for a longer horizon. We are not expecting our economy to slow down very substantially. Bond yields will not come down substantially or stay there for very long. Invest for a time period of one year," says Sabharwal.

After the 10-year government security yield touched 8.463%, it has moved within a range.

Short-term funds and FMPs still look good

On an average, short-term bond funds have returned 6.50% in the past six months and 5.39% in the past one year. These schemes too have increased their duration slightly—from 267 days on an average as of their April 2011-end portfolio to 350 days as per their July 2011-end portfolio. Says Mahendra Jajoo, chief investment officer (fixed income), Pramerica Asset Managers Ltd: “Short-term interest rates are expected to remain more stable than the long-term interest rates and hence they have made good returns in the past six months. They look good going ahead too."

What to do

If you wish to take a bit of risk for the chance of getting higher returns, go for long-term bond funds. Since these funds are marked to market and are open-ended, any fall in interest rates will benefit them (the prices of the underlying securities will rise; the inverse relationship of interest rates and scrip prices at play here).

Apply the same logic for short-term funds. Adds Radhakrishnan: “Short-term funds are marked to market but are subject to lower volatility because their duration is limited (lower than those of long-term bond funds). But if you do not have a risk appetite and do not wish to risk your capital, go for FMPs."

Watch out for exit loads:f you invest in an FMP, your money gets locked till the scheme matures. If you think you may need your money earlier, go for short-term bond funds. Apart from being open-ended, they also give more returns if interest rates start to fall. But most short-term bond funds impose an exit load for withdrawals before 180 days.

Long-term bond funds too, impose exit loads for early withdrawals before 90 days, going up to 365 days.

Illustration By Shyamal Banerjee; Graphics By Yogesh Kumar/Mint