Bond fund investors get a jolt

In recent weeks, the Indian debt market has been doing its best to emulate its more whimsical cousin — the stock market. With bond yields swinging 50-60 basis points intra-day, gilt and long-term debt mutual funds have seen 40-50 per cent of their gains for a whole year wiped out in a fortnight.

Bond fund managers, like their equity counterparts, have been making soothing noises, saying. “These RBI measures are temporary. Every fall in bond prices is actually a long-term buying opportunity”.

Changing for good

But is it really?

It all depends on Ben Bernanke. After all, the current rout in the debt market started with a hint from him that the US Fed was looking to withdraw its quantitative easing (QE) policy.

Foreign Institutional Investors (FIIs) in India reacted to this by selling 20 per cent of their cumulative holdings in domestic government securities and bonds in June and July. This set off a sharp slide in the rupee against the dollar.

This forced the RBI to take drastic action to tighten liquidity and curb speculation. As these moves caught bond markets by surprise, they reacted in a knee-jerk fashion. The cost of overnight money shot up by almost 200 basis points, setting off a similar rise in commercial paper and certificate of deposit rates.

The correction in bond prices has caused unusual mark-to-market losses in liquid and short-term debt funds and dealt a body blow to debt funds which had gone overboard on such bonds.

Overall, gilt and income fund NAVs have retreated by anywhere between 2.5 and 5 per cent in the last fortnight. Their one-year returns, which were hovering at double digits until recently, are now at 7-8 per cent, if not lower.

So, with all this action behind us, is this a ‘long term’ buying opportunity? We don’t think so.

Gilt and income funds can only outperform during periods of falling interest rates. Right now, the RBI’s rate cuts are on hold. Given the structural factors (inelastic imports, sluggish exports) holding down the rupee, it is difficult to say when rate cuts will resume.

Meanwhile, the risk of the Fed actually phasing out the QE remains a live one. If a mild hint about the end of QE caused FIIs to pull out $5.7 billion from Indian bonds in June, what will their reaction be if Bernanke really winds down the QE for good? As the US economy gathers steam, this is what Indian debt investors should be bracing for. A couple of years ago, FII action wouldn’t have affected debt investors because FII participation in the debt markets was negligible, but not now. Though FIIs hold less than 5 per cent of the market’s outstanding debt, the recent episode has shown that FII pullouts can jolt both bond prices and the Rupee.

Too risky

All these suggest two things for debt fund investors.

One, the risk-return trade-off for bond fund investors has just gotten a lot more uncomfortable. Yes, with 10-year gilt yields at 8 per cent, long duration funds can possibly deliver double-digit returns from here, if interest rates fall.

But the question is how much volatility one would have to take to earn this return. Until Bernanke makes up his mind, two-way price swings in bonds may be quite commonplace.

Institutional investors who track yields or US markets real-time may be able to jump in and out of debt and gilt funds to make the most of this volatility. But for retail investors, the risks may simply outweigh the potential returns.

In equities, one may not mind taking on high volatility, because the upside to a good stock can be practically unlimited over the long term. In bonds, the upside is limited.

Two, recent events have also reiterated that gilt funds are not really ‘safe’ in the true sense of the word, just because they carry no credit risks. Interest rate direction can be as hard to call as the Sensex. Managers of dynamic bond funds, who promise to juggle different durations and instruments, have made wrong calls, too.

In the final analysis, if you are a retail investor who cannot actively track debt markets or decipher Fed speeches, it seems best to stay away from gilt and long-term debt funds for now.

With commercial paper rates at 10 per cent, short-term debt funds which earn accrual income, may now offer good returns. If you need liquidity on the tap, opt for them. But if you want more predictable returns, one or two-year fixed maturity plans and good old fixed deposits with banks, should be your top fixed income choices.

>aarati.k@thehindu.co.in

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