Long-duration bond funds benefit most from RBI rate cut

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Last week's surprise rate cut by the Reserve Bank of India (RBI) has boosted returns of long-term bond funds, including income and gilt medium- and long-term funds. Gilt medium- and long-term and income funds have benefited the most by the rate cut, with one-day returns of 0.74 per cent and 0.54 per cent, respectively, data collated from Value Research showed. These funds top the returns chart among debt categories for the last one year as well, with returns of 14.8 per cent and 11.9 per cent, respectively. Liquid funds, which hold much shorter duration papers, were least benefited, with one-day returns of 0.03 per cent.

However, with RBI frontloading its rate cut and a low probability of further cuts anytime in the near future, experts suggested this was not a good time to enter duration funds. According to Dwijendra Srivastava, Chief information officer - debt, Sundaram MF, those who want to come into these funds should wait and watch and investing only if sure there is a case for further rate cuts.

That said he believed that those who were already invested in long-term funds could stay put as there was still some mispricing between the repo rate and the yields of 10-year benchmark government paper.

While the spread between these instruments was generally 40-50 bps, it currently was at around 75 bps, meaning yields could slide further by 15-20 bps, he said.

While the scope for further rate cuts in the near future might be limited, there was likely to be an extended pause before RBI raises rates again, experts said. "We will not have a V-shaped but a U-shaped reversal with a prolonged pause, which will give plenty of opportunities for investors to make money," said Killol Pandya, head - fixed income, Peerless MF.

He expects the 10-year benchmark government bond yields to slip to 7.3 per cent by the end of this financial year from about 7.5 per cent levels now. "The interest rate cycle is close to bottoming out, with one more rate cut in the offing at best. But it's a good time to enter long-term bond funds from an investment cycle perspective," he said. RBI's recent measure to raise limits for FPI investment in government securities, a move likely to bring in new investors and fresh infusion of money, would also bring gains to investors in long-duration gilt funds, said Pandya.

Interest rate risks remain, however. A rate hike by the US Federal Reserve, sudden spike in global crude oil prices and a spurt in domestic inflation could bring about a rethink in RBI's monetary policy stance.

Market participants also believe this is a good time to move from liquid funds to ultra short-term and short-term bond funds. "Overnight rates will go down as they are a function of repo rates, so returns of liquid funds and other accrual based products will head south. Mark to market instruments such as ultra short-term and short-term bond funds will do well as yields will go down in the coming months," said Pandya.

According to Srivastava, ultra short-term and short-term bond funds are likely to earn 50-60 bps higher than liquid funds, owing to higher duration. While liquid funds typically invest in papers with an average maturity period of 30-40 days, ultra short-term and short-term bond funds invest in papers with a duration of 200-300 days and 1,000 days, respectively.

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