Profiting From Bond Funds

About a year ago, I started investing heavily in bond funds as I was expecting the interest rates to go down. At the moment, of course, all these funds are down. I have no immediate need for funds and can hold on to these investments for several years. What would be an optimum period to realise the profit potential of bond funds in the present economic circumstances?

- V Sitaraman

I am assuming that you are referring to long-term bond funds, as these have been the worst hit over the last year. The returns of these funds were adversely affected when the Federal Reserve announced plans to taper its QE programme as FIIs redeemed their holdings in emerging markets like India. This contributed to the sharp depreciation in the rupee, which in turn added to the pressure on inflation and forced the Reserve Bank of India (RBI) to raise interest rates. All these factors contributed to a rise in yields, hurt bond prices and also pulled down the returns of long-duration funds, which are particularly sensitive to rate changes.

You should match your investment horizon to the duration of your fixed income portfolio. For example, if the funds in your portfolio had durations of five years when you invested in them, then you should continue to hold these for the next four years – effectively a hold-to-maturity approach. This strategy should minimise the impact of interest rate fluctuations on your portfolio.

Long-term funds may generate capital appreciation over the next few years as interest rates would eventually fall because of the economic slowdown. Deceleration in growth may limit the upside to inflation, as corporate pricing power is muted. This is reflected in core inflation, which has fallen over the last few months, as shown in the graph.

Food inflation is expected to decrease over the next few months as the 2013 monsoon season was one of the best in recent years and the harvest is expected to be robust.

Moreover, the current account deficit (CAD) may not be an obstacle to monetary easing if exports continue to grow faster than imports. The CAD rose to a record high in the last fiscal, but fell to 1.2 per cent of the GDP in Q2FY14. Hence, India is now less vulnerable to QE tapering, as the country will still be able to finance the CAD even if FIIs redeem their holdings. This is because the central bank has received about USD 34 billion through foreign currency non-resident deposits and a special concessional swap window. The RBI is now better positioned to support the rupee (and hence limit imported inflation), as the central bank’s foreign exchange reserves have increased over the last few months.

Finally, over the next few quarters, supply-side reforms may reduce the pressure on prices if stalled projects are implemented.

Nevertheless, the near-term outlook for interest rates is uncertain. The RBI surprised the markets by not raising the repo rate in its policy review on December 18, but the central bank may be forced to hike rates if inflation does not trend lower.

On December 18, the Fed announced that it would reduce its monthly stimulus modestly. India is now better prepared to deal with the taper, but the rupee may still depreciate (though any decline may be limited) as unlike many of its emerging market counterparts, does have a current account deficit.

Consequently, the long-duration funds in your portfolio may be volatile. You could consider maintaining a laddered fixed income portfolio by investing a portion of your corpus in short-term and medium-term funds to mitigate risk. These funds are generally less affected by swings in interest rates than their long-duration counterparts.

The benchmark 10-year government bond yield was close to nine per cent in November 2011, but this fell to nearly seven per cent in May 2013. During this period, the CRISIL Composite Bond Fund index outperformed the CRISIL Short Term Bond Fund Index, as shown in the table. However, the trend was reversed this year, as the benchmark 10-year yield has risen by about two per cent since May.
* Returns as on December 16, 2013

During the last year, most short-term funds have outperformed their long-duration counterparts and have been relatively less volatile.

In the current scenario, your fixed income portfolio should be geared towards short and medium-term funds to mitigate downside risk. The remainder can be invested in long-duration funds, which may generate higher returns if the interest rates fall. Therefore, holding a laddered portfolio of bond funds with different maturities should help you get the best of both worlds. But remember that your fixed income allocation should be adjusted in line with changes in the economic scenario and the interest rate outlook.