A regular reader of
BW Businessworld wrote in to me recently with a few highly pertinent queries related to debt fund investing. It's worth noting that despite their widespread proliferation, few investors are aware of the many nuances of debt fund investing. This often results in significant strife when yields spike and portfolio returns turn negative (something many debt fund investors believe is impossible), or in the rare situation when debt fund returns are close to zero over a full one year holding period. The answers to the reader's queries, which could broadly benefit all debt fund investors, are presented hereunder in the collective interest of all readers of
BW Businessworld.
How will bond funds perform when interest rates are low and stable? When interest rates are low and stable, returns from bond funds will typically be closer to the YTM (Yield to Maturity) of their portfolios, as the mark to market fluctuations in the prices of the underlying bonds will be low. However, do bear in mind that interest rates aren't the sole influencer of bond prices. For instance, a downward sovereign re-rating could cause yields to spike, leading to negative returns from bond funds. Similarly, the selling of bonds by the central bank to stabilize the Rupee could lead to negative short term returns from bond funds. Longer duration debt funds will be more sensitive to such fluctuations. To sum up, when interest rates are low and stable, switch to short term income funds that have a modified duration of a year or so, and generate returns mainly from accruals. Preferably, make sure the portfolio is at least of a moderate credit rating (50 per cent above BBB) to avert rude shocks from bond defaults.
Will bond funds give negative returns when interest rates are moving upwards? If so, should I move from bond funds to non-bond funds in such case? When interest rates move up, the mark to market prices of bonds fall, impacting the NAV's of bond funds negatively. The extent of the fall will depend upon, among other factors, the average maturity of the bonds in the portfolio, and the modified duration. The "modified duration" of a bond fund represents the sensitivity of a bond fund's NAV to changes in yield. For instance, if a fund has a modified duration of 8 years, and yields rise by 100 basis points, it will have a negative impact of 8 per cent on its NAV (and vice versa). If you're concerned about rising interest rates, there's no need to switch out of bond funds altogether - simply switch from higher duration funds to lower duration (<1 year) ones.
Do "dynamic bond funds" always give positive returns? In short - no, they do not. The returns from dynamic bond funds hinge largely upon the fund manager's ability to make the right 'play' at the right time - accrual, duration, or credit spreads. A successful dynamic bond fund manager will be able to predict when to switch out of long term bonds to shorter term bonds (that is, from a duration to an accrual strategy) and vice versa.
How can bond funds returns be greater than its bond's yield? The bond fund's YTM or "Yield to Maturity" is (especially for longer term debt funds) really just a notional figure. YTM is the return that the fund will realise if all the current bonds in its portfolio are held to maturity; this has a less than slim chance of happening for long term/ actively managed debt funds. Bond funds make returns from accruals and capital gains. Here's a simple example: ICICI Prudential Long Term GILT Fund has a YTM of 7.08 per cent and a modified duration of 8.51 years. Let's assume that you invest Rs. 100 in this fund for a year, and accruals contribute Rs. 6.5. In the meantime, yields fall by 100 bps in the next 12 months (a near impossible situation right now, mind you!) This fall of 100 bps in yields will lead to an average increase of Rs. 8.51 in the portfolio of bonds (as indicated by the modified duration). Your total returns (capital gains plus accruals) will be Rs. 15, or 15 per cent.
The reverse applies too! If yields were to rise by 100 bps in the next twelve months from today, the accrual income of Rs. 6.5 would be completely offset by the mark to market capital loss of Rs. 8.5, and your one-year return from the fund would be closer to -2 per cent.
If I hold a bond fund for 10 years; assuming there is one upward and one downward interest rate cycle, will the fund returns be equal to its yield?Not necessarily, as the bond fund's portfolio will be dynamic. Profits (and losses) will be booked from time to time. As mentioned earlier, the YTM is only a representation of the present portfolio, which might just undergo a complete overhaul the next quarter. The fund returns over a 10-year period will hinge largely on the portfolio buy/sell decisions taken by the fund management team during this time.
Within debt funds, I maintain a 40 per cent allocation to money market oriented short term funds, 40 per cent dynamic bond funds, 15 per cent to corporate bond funds and 5 per cent to Gilt funds. Should I keep this diversification ratio fixed, or I should adjust it from time to time? After the Union Budget 2014, it has become prohibitively expensive, tax-efficiency wise, to make constant tweaks to your debt fund portfolio. If you're unlucky, the tax inefficiencies might just cancel out all the alpha you generate through active management! This dilemma is compounded because it's nigh impossible to predict bond market trends three years hence. The best approach would be to follow a "core and satellite" strategy, wherein you invest 70 per cent of your funds into a fundamentally sound portfolio of dynamic bond funds with a three-year horizon, and keep the remaining 30 percent flexible, possibly switching to high duration funds (such as ICICI Prudential GILT Long Term) when interest rates are high and inflation is under check, and moving back to short term, accrual based funds (such as Franklin India Low Duration Fund) when interest rates are low/stable.
