The Hindu Business Line : Time for long bond funds

The time has come for investors to again actively allocate a part of their fixed-income portfolio to medium-term and long-term bond funds. Such funds have been out of fashion for almost six years now. The overall macro-environment is now conducive for such funds, with the interest-rate cycle turning decisively.

We are in for a sustained period of declining and low interest rates, and in such an environment, there will be an opportunity to derive superior returns by investing in medium to long-term bond funds.

The how of returns: Such bond funds derive their returns from appreciation in the value of bonds. Bond prices and interest rates are inversely related to each other. Bond prices rise when interest rates decline and bond prices decline when interest rates rise. As the interest-rate cycle has changed direction, there is the possibility of a rise in bond prices and sizeable returns.

The phase of a bottoming of interest rates in 2002 and rising interest rates since 2004 meant such funds could not generate attractive returns. As the interest rate cycle has turned decisively with the Reserve Bank of India cutting rates from October 2008, such funds are well placed to capture the emerging opportunities in longer end of the yield curve.

Multiple sources for returns: As the Reserve Bank of India has embarked on lowering interest rates since October — a process that is likely to continue through 2009 — different parts of the yield curve provide an opportunity.

Reduction in yield on government securities, a process that is already underway.

Reduction in corporate bond yield; this process is still at a nascent stage as there is a preference for the safety of government securities.

Reduction in spreads between the yield on government securities and Triple AAA corporate bonds; this, too, is at a nascent stage. As corporate bond yield decline, the spreads will also decline offering an opportunity.

Phased reduction in yield across the yield curve in terms of tenure of the securities.

Phased reduction in yield across the credit-rating curve.

Mispricing in any one or more of the parts of the yield curve will also provide trading opportunity.

Rationale for lower interest rates : The significant reduction in commodity prices, prices of crude (down 70 per cent from peak), the emphasis on providing a boost for GDP growth and a decline in inflation rates, which is likely to sustain, provide a sound basis for expecting interest rates to continue their declining trend.

Across the developed world and China as well as other emerging market countries, there is an emphasis on trying to soften the effect of recession and/or moderate a slowdown in the economy.

There have rate cuts across multiple geographies. The global trend also points to and provides support for a decline in interest rates and a sustained period of low interest rate in India. Specific to India, the pressures on the current account deficit has eased significantly with the decline in crude prices.

Ditto for fiscal deficit, too, as lower crude prices will reduce the outgo on account of oil bonds and fertilizer bonds though fiscal stimulus packages and other outgo may enhance the pressure; a potential source of severe constraint has been removed for now.

The commencement of oil and gas production from next year will also have a favourable impact on the twin deficits. This was not the position between March and October 2008 when the world was reeling from the spike in crude prices from $90 to $147 barrel. The changed situation on the twin deficits will also support the case for lower interest rates. This augurs well for bond prices and medium to long-term bond funds.

(The author is Head, Fixed Income, Sundaram BNP Paribas Asset Management. Extracted from the AMC’s monthly newsletter ‘The Wise Investor’)

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