Illustration: Ajay Mohanty
Debt funds have had a poor run last year with the spike in yields and expsoure of some mutual fund houses to IL&FS. The volatility in the movement of bond yields seen last year is expected to continue.
The domestic inflation trajectory, political developments ahead of the national elections this year, the movement in global crude oil prices and global interest rates will be factors that would impact the Indian bond market, according to experts. Global central banks are expected to tighten liquidity, which may have a bearing on the Indian rupee, equities and bonds if foreign flows turn negative.
Investors will need to exercise caution and be mindful of both interest rate and credit risks which could impact their portfolios.
“It would be prudent for the existing debt investors to reduce their exposure to long-duration bond funds and credit funds in this current rally. For debt fund allocation, investors should focus only on debt funds with shorter maturity profile and good credit quality portfolio,” said Pankaj Pathak, fund manager–fixed income, Quantum Mutual Fund.
Bond prices and yields are inversely proportional; as prices increase, yields fall. Shorter-dated bonds are not immune to rising rates, but their returns tend to be less volatile than longer-term bonds.
“A high-quality accrual strategy should work at this juncture, provided investors stay out of credit risk,” according to Vidya Bala, head of mutual fund research at FundsIndia. “Although the duration space has started looking attractive, it is better not take duration calls given the volatility. Existing investors can hold duration funds, but should not take any fresh exposure.”
Accrual funds focus on earning interest income primarily from the coupon offered by securities they hold in their portfolio. Duration debt funds take a call on interest rates and position their portfolios accordingly.
Liquid funds have emerged the top performers in the past year, with one-year returns of 6.9 per cent. Credit Risk and Dynamic bond funds, on the other hand, were at the bottom of the pile, with returns of 5.3 per cent and 5 per cent, respectively.
Some fund houses had taken significant exposure to debt papers issued by IL&FS and its subsidiaries last year. These schemes had to take a sharp haircut on their exposure, following the multi-notch downgrade of parent IL&FS. The markdowns impacted net asset values of the schemes, and returns.
The tight liquidity environment made it difficult for mutual funds to offload commercial papers of duration as low as one or two days. Some large fund houses even borrowed from banks to meet the incremental redemption requests last month.
Yields of 10-year government papers have seen wild moves in the past year, touching a high of 8.18 per cent. The Reserve Bank of India increased interest rates by 50 basis points last year, and has changed its stance from neutral to calibrated tightening.