Turn Of The Tide: Should You Invest In Debt Funds Now?

The past few years have been challenging for debt fund investors, but the case for adding them in your portfolio is now more compelling than ever

With equity investing catching the fancy of investors in recent years, especially after the Covid-19 pandemic, debt funds have often remained on the sidelines. This is especially true for retail investors who enter the market to cash in on the bull run, as if it’s a  magical get-rich-quick formula.

It is also a fact that fewer retail investors really think about investing in debt funds. These usually include the ones who understand the importance of asset allocation in a portfolio, those who are saving for a short-term goal and retirees looking for a relatively safer instrument to park their corpus (see Why Should You Invest In Debt Funds?).

These investors saw their patience tested for the last few years as interest rates bottomed during Covid-19 as governments and central banks, including India’s, tried to fight the pandemic and its aftermath by lowering rates. Usually, when rates are lowered, debt funds do well, but since foreign portfolio investors (FPIs) became net sellers, they suffered. From May 2022, the Reserve Bank of India (RBI) reversed its stance and as rates started going up, returns from debt funds took a hit as is usually the case. Now, with RBI keeping rates stagnant for about a year and expectations of a rate cut later in the year, the tides may turn for debt funds.

Does that mean it’s the right time to buy debt funds? We try to answer that question by putting the Indian debt market in context for the last three-four years to enable you to make the right decision, and some others that are crucial for debt fund investing.

The Post-Covid Story

Debt fund investors got a rude shock when the interest rate bottomed out in 2020 but they didn’t gain due to other factors. That year, when the pandemic struck India, RBI lowered the rate by 75 basis points (bps) in February and an additional 40 bps in May. This rate cut brought the interest rate to an all-time low of 4 per cent, remaining stagnant for around two years.

In early 2022, the bond market saw the beginning of the interest rate hike cycle across most developed markets and emerging economies in a bid to tackle inflationary pressure. The US Federal Reserve raised policy rates by an unprecedented 550 bps during the cycle. At the same time, RBI increased the repo rates from 4 per cent to 6.5 per cent. This led to a sharp upward shift in the entire yield curve and hit bond prices. The price of the bond and yield are inversely related.

Returns were hit to lower single digits in the calendar years 2021 and 2022 due to the decline in prices of underlying bonds in the portfolio and the yield crash. In both these years, returns from the bond market failed to surpass the average inflation levels in the economy.

For instance, dynamic bond fund, which manages its portfolio dynamically according to the varied interest rate scenario, posted average returns of 3.32 and 3.067 per cent in 2021 and 2022, respectively. Likewise, corporate bond funds, one of the largest categories in terms of assets under management (AUM) of Rs 1.46 trillion as of February 2024, posted abysmal returns during the same period. The category average return was 3.52 and 2.77 per cent, respectively, in 2021 and 2022.

The year 2023 was a rollercoaster ride for the global bond market because of conflicting narratives centered around persistent inflation and expectations of an upcoming recession.

Turn Of The Tide

The tide seems to have turned in 2024. Many factors hint at a potential downward trajectory for Indian bond yields offering a buying opportunity for bond investors. The anticipated shift in the US Fed’s policy is a factor that can influence Indian bonds positively. Rate hikes have peaked, which signals an imminent rate-cutting cycle as inflation is cooling down with slower global growth (see Cooling Inflation Raises Hopes).

Inflation has started receding around the world, interest rates have peaked and other macro economic data such as fiscal deficit and current account deficit are all pointing to a rate cut.

In India, after consistently raising policy rates for six times, RBI paused the rate hikes since February 2023, when the last hike was seen. Given that inflation has stayed within RBI’s upper tolerance band of 6 per cent for the last six months, there is high anticipation of a rate cut. Says Amit Tripathi, chief investment officer (CIO), fixed income, Nippon Mutual Fund: “The policy rates have peaked and are headed directionally down. The timing and quantum of the down-move will depend on multiple internal and global factors.”

The quantum of rate cuts and their pace will be different for different countries as they will be dictated by their respective state of economies. Says Rahul Pal, CIO fixed income, Mahindra Manulife Mutual Fund: “All eyes are on the US interest rates. The market expects the US Fed to cut its benchmark rates around 75 bps through the calendar year. Such rate cuts may also nudge RBI to possibly change its monetary policy stance and possibly start cutting rates.”

Though the US Fed kept rates unchanged in its March 20 policy meeting, eventually cuts may follow. In the Federal Open Market Committee (FOMC) meeting, 19 US policymakers are expecting a three-quarter-point rate cut this year, while others see two or less than that. After the announcement, the market believes there’s a higher probability (about 70 per cent) that the Fed will start cutting interest rates during its June policy meeting, whereas earlier only 55 per cent of the market expected rate cuts, according to a few experts Outlook Money spoke to.

As far as India is concerned, “we believe that RBI may consider rate cuts from October 2024 onwards after thoroughly reviewing the new Budget, ongoing inflationary pressures, the global growth-inflation dynamic and the policy rate,” says Dhawal Dalal, CIO fixed income, Edelweiss Mutual Fund.

In September 2023, JP Morgan announced it will be adding Indian government bonds to its emerging markets bond index (JP Morgan GBI-EM-GD) starting from June 2024. This inclusion will lead to higher foreign inflows in the Indian debt market. “JP Morgan’s Bond index inclusion could alone lead to FPI inflows of $25 billion or Rs 2 lakh crore in the Indian debt market,” writes ICICI Securities in its report published in February 2024. The report adds that apart from JP Morgan’s GBI-EM-GD index, Bloomberg Global Aggregate Index (Global Agg) is also likely to include Indian bonds. The index has an estimated assets under management (AUM) of $2.5 trillion and with 0.6-0.8 per cent weight, additional potential inflows could be to the tune of $15-20 billion. Such inflows coinciding with the global rate-cut cycle will push bond yields lower.

Since the announcement of this inclusion, FPIs have been pouring money into the Indian bond market. After being net sellers in three consecutive years—2020, 2021 and 2022—FPIs bought Rs 68,663 crore worth of bonds in 2023 (see FPI Bond Rush).

But will this higher demand from FPIs boost bond prices? Abhishek Bisen, head, fixed income, Kotak Mutual Fund, explains, “When the supply of any product is constrained and demand grows, it leads to higher prices. The same phenomenon will be seen in bond prices, too.”

Experts believe that the year 2024 may be a decent one for the bond market, as they anticipate RBI to cut policy rates, which means debt funds are likely to do well. If the interest rate decreases, the new bonds with the same face value and the same tenure will offer a lower interest rate, thus making existing bonds attractive and pricier, which will consequently lead to a rise in the value of debt fund investments that would have been accumulating units in the low phase.

Which Funds To Invest In?

The anticipation of a rate cut builds the case for increasing duration in the fixed income portfolios to benefit from decent accrual and potential price appreciation down the road. Fund managers have started adding longer duration bonds to their portfolios to gain from the rate cut.

Says Dalal: “We have already added duration by adding 14- and 30-year Fully Accessible Route (FAR) eligible securities into our government securities (G-sec) Fund. We also prefer government bonds over state development loans (SDL) or corporate bonds as we expect credit spreads to widen in 2024 due to the demand-supply dynamic.”

A higher duration strategy helps in a falling interest rate regime as longer-maturity bond prices rise more than that of shorter-tenure bonds. “With hopes of RBI cutting rates, a higher duration strategy (seven years-plus) would help portfolios capture market gains and generate healthy returns for the investor,” says Pal. Thus, longer-term debt funds will see net asset values (NAVs) rising.

However, you will have to look for opportunities depending on your risk appetite and investment horizon.

“We expect rate cuts of 50 bps over next 1 year and yield curve is likely to steepen. We see scope for capital gains and the total return is likely to be higher than other trading fixed income options,” says Bisen.

He suggests that investors with relatively lower risk appetite can consider corporate bond fund with one-year-plus investment horizon, over longer-duration schemes.

Also, different categories of funds follow different portfolio strategies, so the impact of rate cut will vary. “Over the next 12-15 months, the risk return is more balanced in the short-to-medium part of the yield curve given the partial run-up already seen in long-duration debt funds. Products like short-term debt fund, corporate bond fund, banking and public sector undertaking (PSU) debt fund are all well-positioned to capture this trend,” says Tripathi.

Some fund managers believe that funds that invest in G-secs will have an edge over corporate bond funds. “Our preference is to invest in government bonds over SDLs or corporate bonds in 2024. This is based on our view that credit spreads are likely to widen further in 2024 due to the higher supply of SDLs and corporate bonds,” says Dalal.

He recommends that investors should consider investing in G-sec funds or bond exchange-traded funds (ETFs) or bond index funds with a predominant exposure to long-dated government bonds and SDLs with an average maturity between 10 and 20 years and an investment horizon of at least one year, depending on their individual risk appetite. He, however, cautioned investors that these funds may exhibit higher daily volatility as compared to corporate bonds funds, but may be superior from the risk-adjusted returns and total return perspective, in 2024.

Says Pankaj Pathak, fund manager, fixed income, Quantum Mutual Fund, “With a high starting yield and expectation of a fall in bond yields, investors should consider long-term government bonds. Also given the expected fall in bond yields, dynamic bond funds with flexibility are more suited.” However, investors need to have a longer holding period of at least 2-3 years to ride through the intermittent volatility, and those with shorter investment horizons and low-risk appetites should stick with liquid funds, he added.

Things To Consider

Not all debt mutual funds may be suitable for investment. You need to assess them on certain parameters. The other option is to look at our OLM 50 list of mutual funds, which we will revisit in the June issue.

Rating: If you are investing in a corporate bond fund, it is important to look at the ratings of the papers in the portfolio. Corporate debt instruments have credit ratings. The credit profile of the fund’s portfolio shows the level of credit risk taken by the debt fund. A large investment in highly-rated papers implies the fund is taking lower credit risk. Lower credit rating implies that the fund is investing in low-rated papers for a higher portfolio yield. This may give you higher returns, but at the same time carries higher risk.

Yield: It is the measure of interest income earned by the bonds. Bond funds which give higher returns have a higher portfolio yield. In a stable interest rate scenario, yield would be an approximate measure of the returns. In case of falling or rising interest rates, yield does not account for trading gains or losses from buying and selling bonds.

Maturity: Looking at the maturity will help you understand the exposure of the fund to bonds with different maturities. In a falling interest rate scenario, debt funds would have higher portfolio maturity. So, it would be prudent to go for funds with higher maturity.

Duration: Duration measures the price sensitivity of the fund’s portfolio to the change in interest rates. Funds with a longer duration would be more sensitive to interest rate changes. This means funds with longer duration will have higher volatility. So, keep your risk profile in mind while looking at this factor.

Remember that different categories carry different risk and reward. So, it is always advisable to match the duration of the investment with your goal. For instance, if you are investing for your short-term financial goals, say, 1-2 months ahead, it is advisable to invest in liquid fund and/or ultra short-term fund. Likewise, if your financial goal is around a year or so, you may consider a short-term fund, and so on.

Also, make sure you don’t get carried away with just returns. Checking other key fundamentals, such as the fund house pedigree, funds’ past track records and others is equally important.

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Why Should You Invest In Debt Funds When Equity Is Soaring?

With the equity markets rising, you may wonder if it makes sense to consider debt funds at all. But you should always remember that a prudent investment portfolio needs to have a balance between equity and debt.

With the equity component of any portfolio soaring now, it is an opportune time to look at your asset allocation and rebalance if required. A simple way to do this is to book profits from equity instruments and invest the same in debt to maintain the original asset allocation. But you could do this in a planned manner since the prospects of investing in debt are looking up.

With the possibility of interest rate cuts imminent, taking a medium- to long-term bet on debt schemes is a smart move, which is likely to pay off handsomely in the future. For instance, the yield on a 10-year government bond is 7.096 per cent now (see Softening Bond Yields) and has been falling steadily over the past six months—from 7.432 per cent in October 2023 to the current levels—and the prices are becoming more attractive. This might give a fillip to debt mutual funds. For investors, this situation augurs well because bond yields and interest rates are positively correlated, with both moving in the same direction.

The economic indicators are pointing towards a rate cut in the future, which could lead to an increase in bond prices. Debt investors, especially those investing into medium- to long-term funds, are likely to get the benefit of declining interest rate in the form of capital appreciation on their bond portfolios coupled with coupon income.

kundan@outlookindia.com