What Should Debt Fund Investors Do Now?

Post the demonetisation announcement, bond yields nosedived; leading to supernormal returns from duration based debt funds for a short while. Debt funds essentially make money in two ways - by accruing coupon payments from their underlying bonds, and through capital gains when bond prices move up. Falling yields are synonymous with rising bond prices, and vice versa.

In November, the yield on the 10-year 6.97 per cent G-Sec fell to as low as 6.20 per cent - even below the repo rate of 6.25 per cent; a highly unusual phenomenon. This dramatic fall in yields was triggered by a temporary surge in G-Sec buying, on the back of the unexpected and sudden rise in banking liquidity. As on date, the 10-year yield stands at a more rational 6.44 per cent.

The recent flip-flop in yields has once again demonstrated the perils of investing based on incomplete information. Many debt fund investors, lured by their impressive 1-year returns ranging from 15 per cent to 18 per cent, rushed headlong into longer duration debt funds after bond prices had already spiked. They're sitting on losses of 2-3 per cent now; investing in a fund after it's NAV has already gone up is akin to bolting the door after the horse has fled.

Modified Duration
When it comes to debt fund investing, investors need to watch out for the "modified duration" of the fund they're committing money to. Put simply, the modified duration of your debt fund is an approximate indicator of the impact of a 100 bps fall or rise in yields on your fund's NAV. For instance, the modified duration for Birla Sun Life Dynamic Bond Fund of 8.32 years as on date; implying that a 1 per cent change in yields will impact the fund's NAV by 8.32 per cent. In other words, investors in this fund can expect a 4 per cent capital gain if rate cuts progress along expected lines (50 bps in the next 3-6 months) and yields fall to 6 per cent or thereabouts as a result.

On the contrary, Birla Sun Life Cash Manager, another debt fund from the same fund house, has a modified duration of just 0.97 years. Thus, the impact of a 50-bps rate cut on the fund's NAV can be expected to be less than 0.50 per cent. Do bear in mind that the reverse applies too: when yields rose 25 bps or 0.25 per cent over the past few weeks, Birla Sun Life Dynamic Bond Fund's NAV fell by approximately 2 per cent - in line with its modified duration.

Yield to Maturity (YTM)
The "Yield to Maturity" or YTM of a fund's portfolio is the other number to watch out for. The is the annualised return that the fund would realise if it held all its portfolio securities to maturity. Needless to say, this number bears limited significance in the case of longer term debt funds which will not be holding many of their securities to maturity; however, they provide a fair indicator of the kind of returns one could expect from short-term debt funds such as liquid funds and cash funds.

Debt Fund Investing - 2017 Strategy
On that note, let's consider the smartest course of action for debt fund investors to take right now. Rising crude prices notwithstanding, lower inflation and reduced interest rates seem to be on the cards over the next 3-6 months. The 10-year yield could in fact fall by a further 40-50 bps in the coming months of 2017, leading to capital gains from longer term debt funds. Those already invested in long-term debt funds or dynamic bond funds with high modified durations could stay put till the 10-year yield hits 6 per cent or so, and then switch out to shorter duration funds such as income funds thereafter.

Those who are sitting on 2-3 per cent losses from debt funds after investing in November or December 2016 are advised to stay put for the next 6-8 months; it's likely that your losses will be covered, and that you'll in fact be sitting on profits by then. Having entered based on past returns and limited information, do not make the second mistake of exiting based on one-month performance.

Overall, a prudent approach remains key; a balanced allocation between short term and long term debt funds is the best approach now. It's unlikely that the trend of falling yields will continue unabated, implying that the risk-reward ratio from long-term debt funds will turn unfavourable at some point this year. Debt fund investors need to reset their return expectations to 8-8.5 per cent per annum at that stage (remember, that's still a significantly better return than deposits).

The Bottom Line
Stay invested in long-term debt funds till the 10-year yield hits 6 per cent, and then switch to funds with a modified duration of 2 to 2.5 years thereafter.