18 February 2017

Debt funds - What lies ahead?

In the past one year, Gilt funds, Dynamic bond funds and other medium to long term bond funds gave excellent returns. Excellent because it’s truly an extra ordinary scenario when fixed income instruments end up giving you close to 15% p.a. returns. Alas, if only these returns came every year there would have been no need to break our heads over number crunching and generating returns.

The following events were the reason why these instruments gave such high returns:

i)                    Rate cut cycle by RBI
ii)                   Demonetization

Let’s go into some detail because you MUST know about your money.

Rate cut cycle by RBI:

RBI has been on an interest rate cutting spree for the last 18 months or so. Bond prices are inversely proportional to interest rates, so when interest rates fall the bond prices go up and vice versa. We save the explanation for another report as it is little complicated.

Repo Rate Chart (RBI)

The above chart depicts the fall in REPO rate from 8% to 6.25% over the last 18 months. This pushed up the prices of existing medium to long term bonds and gave handsome returns to their investors.


When the Government asked people to go deposit their old notes in the banks, the banks were flooded with money. Now as per the governing regulations, the banks must maintain their deposits in specified assets which include sovereign bonds (GILT). How much? That is determined by the Statutory Liquidity Ratio or SLR. So, heavy buying was seen in medium to long term government securities and the prices of these securities shot up overnight and gave investors astronomical returns.

See the chart on the next page to get a visual idea of the overnight increase in prices of GILT securities. We have used L&T Gilt fund as an example.

L&T Gilt fund returns chart

So, what lies ahead for debt investors?

-         -  No more demonetization
-         -  Rate cut cycle nearing an end

The above two points mean that we won’t see double digit returns in debt funds anytime soon unless it is some doomsday scenario. For example, a war breaks out and markets are crashing and thus investors start dumping stocks and run to the so called “Safe Assets”. Infact, if you buy any medium to long term debt fund now, you will see hardly see any returns as bond prices will now consolidate. So, does that mean we no more invest in debt funds? Not really.

Demonetization was unexpected and an icing on the cake for our portfolio which was 68% in debt funds. Our main ideology was that RBI will aggressively cut rates and debt funds would give close to 10% to 11% returns annually. We got close to 15% thanks to Demonetization. Now that we see diminishing returns in medium to long term debt funds, we shift to shorter duration debt funds. Why? Because these bonds are less sensitive to interest rates.

For example, consider this:

Average Maturity
L&T Gilt Fund
Long term
9.60 Years
L&T Ultra Short Term
0.82 Years
L&T Liquid Fund
Extremely Short
0.06 Years
The shorter the average maturity of the holdings of a fund, the lesser the sensitivity to interest rates. So, this year which funds do we invest in and in what proportions? We have considered the following points while selecting the funds for our clients:

 Assets Under Management
Average Maturity
Modified Duration
Expense Ratio
Credit Rating
Exit Load
Ease of Transactions

Always keep in mind - Choose "Growth" option and not "Dividend" as it is more tax effective and thus gives higher post-tax returns.

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