Get ready for debt funds

"Eight-nine months ago, we started investing in debt for some clients. We're now looking at yields of 9.5-10.5 per cent on these investments," says Kartik Jhaveri, director, Transcend India, a financial planning firm.

With the Reserve Bank of India (RBI) cutting rates four times - a total of 125 basis points - this calendar year, Jhaveri is on a strong wicket with his debt fund investments.

When interest rates fall, bond prices go up, improving the returns of especially medium-to-long-term debt funds significantly. In the past year, the category average returns of medium-term and long-term gilt funds have been 10.34 per cent, third highest amid all mutual fund (MF) schemes. Only pharmacautical funds with a 19 per cent return and small-cap funds with 11.1 per cent have done better.

The top performer has been BNP Paribas Government Securities Fund, which has returned 12.67 per cent annually. A large number of other schemes have returned between 10 per cent and 12 per cent.

Obviously, Jhaveri intends to stay invested in debt funds for at least the next two to three years. "We are aggressively looking at schemes that invest in government and corporate bonds because interest rates seem to be on a downtrend for quite some time," he says.

Apart from Jhaveri, a large number of financial planners are advising debt funds aggressively. Even retail investors are getting into them.

Where to invest

Nilesh Shah, managing director, Kotak MF, believes that as RBI succeeds in lowering inflationary expectations, there will be more policy rate cuts in calendar year 2016. "In a falling interest rate scenario, it is important to lock into coupons for longer maturities. Duration funds like gilt funds and income funds provide a good opportunity to investors. This investment will require a three year-plus view for availing tax benefits. Another space which is exciting is credit accrual funds," says Shah.

Some fund managers also recommend credit risk funds but to a limited degree. For example, Jhaveri feels 20-30 per cent of the portfolio can be invested in these funds as well.

Credit accrual funds

These are quite a hit with financial planners. Suresh Sadagopan, director, Ladder7 financial advisors, believes investors who want to put money in fixed deposits should go for these. "Credit accrual funds are typically meant for two kinds of investors - one who is looking for park his money for, say, 12 to 18 months, and if you are looking at safe returns, along with tax benefits."

Financial planners like accrual funds because these focus on earning interest income from the coupon offered by bonds. Accrual funds could also earn some returns from capital gains, but these typically tend to be a small portion of their total return. Another characteristic is that these have a buy-and-hold mandate. So, an investor who goes through the portfolio has, more or less, an idea of the expected return.

There are many schemes by leading fund houses in which the fund manager holds high-quality debt papers of banking and public sector units of less than two years. However, Sadagopan warns that before investing, investors should match their requirement and end-use with the tenure of the scheme. "Investing in a five-year fund when you need the money in two years is not the best way to invest," he says.

Duration or dynamic bond funds

Fund managers of these schemes have a lot of liberty, as they can keep changing their papers according to the situation. They have the flexibility to move into short-term or long-term instruments, depending on the fund manager's outlook on interest rates. If the manager expects rates to fall in the near future, he will start taking exposure to longer-tenure debt paper or position the portfolio at the shorter end of the curve. In duration funds, the focus is on generating a significant portion of returns from the capital appreciation that occurs when interest rates decline.

Credit risk funds

While duration or dynamic and credit accrual funds are favourites of most financial planners because of the safety, along with the good returns these schemes can generate, another recommendation from both fund managers and financial planners, though to a lesser degree, are credit risk funds. These funds have got a bad name after the default by Amtek Auto and JPMorgan's decision to side-pocket the papers.

Credit risk funds are those in which the fund manager takes a credit risk to improve returns. So, the quality of paper might see some compromise. Unlike gilt funds and income funds, which invest largely in AAA-rated paper, these invest across the credit spectrum. Typically, a large chunk of their portfolio is in AA or lower-rated paper. Since they take a higher risk by investing in lower-rated paper, they have the potential to give higher returns. And, as a result, if you want to get higher returns but are willing to take the risk as well, these might be good for you.

Sadagopan suggests another variant. "There are schemes in which the fund manager uses the dynamic strategy, along with a small portion of credit risk. This kind of fund is ideal for the retail investor because it will give the scheme some spike," he says.

Shah says investors will have to choose this category carefully, as risk management is key to generate sustainable return. Funds with credit research capabilities, local roots and connect to understand the risks of credit and structure should be preferred to manage risk and generate return.

Short-term and ultra short-term funds

These funds work well in a rising interest rate regime, as there is a lot of action in the short-term papers. However, as Sadagopan says, they are ideal for parking short-term liquidity and not for generating substantial returns. Jhaveri is moving money from these schemes to longer-term ones.

Most experts believe that the next two to three years will be good for debt funds. Most expect double-digit returns from these schemes. It's time to invest more in debt funds.

Duration funds like gilt funds and income funds provide a good opportunity to investors. This investment will require a three-year-plus view for availing tax benefits. Another exciting space is credit accrual funds. Spreads on high-yield paper have widened in the past few months due to various factors. Funds, which have appropriate structuring capabilities will be able to take advantage of higher yields in this segment. Tax-free bonds also provide a good opportunity, from a trading as well as investment point of view, to lock yields.


MD, Kotak Mutual Fund


While the markets have been largely range-bound in the past two to three months but with growth outlook positive, inflation contained at five per cent levels, real rate of return on one-year T-Bill at 1.75 per cent, there is a scope for a further 25-50 bps rate cut. We expect investors in bond funds to make further gains due to a positive macro economic scenario, sustained fiscal discipline, and low inflation. We recommend dynamic bond funds and income funds to benefit from the softening of interest rates. Credit fund/accrual funds are advisable to tap the current levels of interest rates, coupled with steady growth.


CEO, Birla Sun Life Mutual Fund

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