BONDS. Bet on rates, not upgrades

After a splendid run last year, when long-term bond funds delivered double-digit returns, bond investors were left panting for more in 2015. But what fell into their laps was a modest 5-6 per cent return which, going by the book, is an anomaly of sorts. In the past, bond markets seemed to be accurate in their interest rate expectations. This is what led to the rally in bond prices in 2014, when the yield on the 10-year government bond fell sharply in anticipation of a rate cut by the RBI.

But this theory was turned on its head in 2015, as the yield on government bonds remained stubbornly high, even as the RBI slashed its key policy rate by 125 basis points during the year. The uncanny gap of one percentage point between the repo rate and the yield on the 10-year G-Sec is a marked deviation from the past in a downward rate cycle.

Long-duration gilt funds that primarily invest in government bonds thus delivered mediocre returns. But top performing bond funds that take on credit risk delivered a higher 8-9 per cent return in 2015. These funds earn higher interest by investing in lower-rated (non-AAA rated) bonds.

Go long So, what should bond investors do now? Let us start by understanding where domestic rates are headed. The RBI is likely to resume its rate cuts post the Budget when clarity on the fiscal front emerges. While inflation has been trending higher recently, a downward surprise against the 5.8 per cent targeted inflation for January 2016 will pave the way for more rate cuts by the RBI. In the worst case scenario, even if the RBI does not cut rates in a hurry, the spread between the repo rate and the yield on the 10-year G-Sec offers enough headroom for a bond rally.

The adverse demand-supply dynamics that were at play may also get a helping hand from the RBI’s open market operations (OMOs) that will suck out the excess supply of bonds. Against this backdrop, investors who have already invested into gilt funds should sit tight and not let near-term hitches bother them. For those sitting on the sidelines, this may be the right time to hop on the bandwagon as the current 7.7 per cent yield on G-Sec offers a good entry point for long-term investors. If you are still averse to taking interest rate bets, invest in dynamic bond funds that have the flexibility to switch between short-term and long-term bonds.

Stay clear of credit risk But investors should stay clear of the riskier corporate bond funds, particularly those investing a chunk of their assets in low-rated bonds. The higher returns that many of these funds have delivered in 2015, are early warning signals. An increasing risk environment should ideally increase the yields on lower-rated AA and A bonds, to price in the risk premium. But the yields on AA bonds have fallen by 50 basis points while those for A rated bonds have gone up by a mere 20 basis points.

In the past, the spread between the yield on G-Secs and AA rated bonds has been close to 1.5-2 percentage points. The current 80-90 basis points spread does not justify the risk attached to these bonds. If the credit quality deteriorates, then funds having a larger exposure to lower-rated bonds could end up in a soup.

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