Gilt funds with a return of 11.1% YTD, while medium to long duration funds and dynamic bond funds with returns of 9.2% and 9.3% YTD, respectively, benefitted most in this period of declining yields.
Gilt funds with a return of 11.1% YTD, while medium to long duration funds and dynamic bond funds with returns of 9.2% and 9.3% YTD, respectively, benefitted most in this period of declining yields.

Fixed-income market cheers, debt funds with duration of 2-4 years to benefit

  • Current growth slowdown is a combination of cyclical, durable and structural factors
  • The top five funds in the short duration funds category gave a return of 7.64% year-to-date (YTD), while corporate bond funds gave a return of 8.95% YTD

The Reserve Bank of India (RBI) announced a further 25 basis points (bps) cut in the repo rate on Friday, bringing it down to 5.15%. This has left a positive impact on the fixed-income markets, said market participants. “The policy outcome was pretty much baked into the yields since most market participants were expecting a rate cut of 25 bps which is why we had seen a rally ahead of the event," said Lakshmi Iyer, head, fixed income, at Kotak Mahindra Asset Management Co. Ltd. “It will impact the yield curve favourably especially the short- to mid-end of the yield curve which will continue to be a sweet spot," she added.

Source: Value Research
Source: Value Research


“While the policy rate cut will offer a positive backdrop for the longer end of the yield curve, the more pertinent question for that segment is the fiscal position. Many of the supply side worries have already been built into the price. Gradually, we will see yields at the longer end of the curve also coming down. Today there is a new 10-year benchmark and, hopefully, that too will give an impetus," said Shriram Ramanathan, head, fixed income, L&T Mutual Fund.

Here’s how different categories of debt funds will benefit from the policy measures.

Debt funds such as short duration and corporate bond funds form part of the core portfolio of an investor’s portfolio. These funds, typically, hold portfolios with durations of one-and-a-half to two-and-a-half years, which allows them to reap some benefits of price appreciation in bonds as a result of yield reduction in response to rate cuts but without making the returns too volatile.

The top five funds in the short duration funds category gave a return of 7.64% year-to-date (YTD), while corporate bond funds gave a return of 8.95% YTD. “The AAA spreads in the two and three years parts of the corporate bond curve will continue to compress given that there is still risk aversion at play and money is flowing only into top-rated AAA rated companies," said Ramanathan. The expectation of some more rate cuts, positive liquidity and continued risk aversion bode well for these funds.

Gilt funds with a return of 11.1% YTD, while medium to long duration funds and dynamic bond funds with returns of 9.2% and 9.3% YTD, respectively, benefitted most in this period of declining yields. Bonds with a longer duration see a greater impact on their prices of any change in yields. “Directionally they are headed lower but a significant move lower in the long-term yield will happen only when there’s clarity on the fiscal situation," said Ramanathan.

Ultra-short and low duration funds benefitted from price appreciation too. The top five ultra-short funds generated a return of 9% as compared to 7.9% in 2018. Low-duration funds earned 9.2% YTD against 7.6% in 2018. “There is a lot of emphasis on transmission and these funds will benefit when the yield levels in bank CDs (certificates of deposits) come down," said Ramanathan.

However, overnight and liquid funds that earn most of their return from interest income took a hit and they will continue at the same pace going forward. In the period since the beginning of the current year, overnight and liquid funds saw returns of 4.38% and 5.35% YTD, respectively. In 2018, these categories saw an average return of 5.95% and 6.88%, respectively.

What you should do

With the focus on transmission of lower interest rates being high, fixed-income products that earn from interest income will see lower returns. For investors who seek the comfort of assured returns from their debt portfolio, government-administered small savings schemes may be the most suitable despite lower rates.

Investors for whom assured returns are not a priority should go for short duration funds and corporate bonds. The investment decision in overnight, liquid, ultra-short and low duration funds should continue to be driven by the liquidity and stability they bring to the portfolio.

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