In a falling In a falling interest rate cycle, it is only natural for medium- to long-term mutual fund debt investors to expect a higher than normal return on investments on account of a rise in bond price.
However, contrary to expectations, a 125 basis point (100 basis point is 1 per cent) cut in repo rate (at which RBI lends to commercial banks) by the Reserve Bank of India over the last 11 months did not alter the yields of Government Securities (G-Sec) and therefore there have been no additional gains for investors. If the 10-year G-Sec yield stood at around 7.7 per cent in January 2015, the yield currently stands at 7.77 per cent. As a result the bond prices did not rise and the existing investors in debt funds, including the investors of gilt funds (that invests into government securities), have not benefitted from the RBI rate cuts.
The average return generated by short-term gilt funds over the last one year currently stands at 7.6 per cent whereas the average return by short-term debt funds have been 8.3 per cent. By comparison, the average return generated by medium- and long-term gilt and income funds stood at 6.9 per cent and 7.4 per cent respectively and is much lower than what was expected.
Even as there are growing concerns over the timing and quantum of future interest rate cuts by the RBI, experts say that investors should not lose hope for better returns. Both, industry players and investment experts point that while the returns may not have been on expected lines and have been impacted by events such as looming interest rate hike by the US Federal Reserve, fall in FII demand for bonds and uncertainties surrounding the currency movement, the returns in the medium- to long-term may improve as and when the uncertainties in the market subside and the transmission of RBI rate cuts happens into bond yields.
“The G-Sec yields are at the same levels where they were at the beginning of the year despite the fact that the RBI has reduced the repo rate by 1.25 per cent through the year 2015. Market has been wary of the uncertainty around FOMC meet ahead where it is largely expected that US Fed will raise rates by 0.25 per cent,” said Rahul Goswami, CIO, Fixed Income, at ICICI Prudential AMC.
While there were talks of a possibility of double-digit return from debt funds when the RBI began the rate cut cycle in January 2015, the absence of transmission of those rate cuts in the bond yields have resulted into subdued returns for investors and have thus been a disappointment. The performance has especially lagged over the last six months and that too for medium- to long-term duration bonds. The average return generated by medium- and long-term gilt funds over the last three months stand at 1.53 per cent, however that for the short-term gilt funds stood at 1.97 per cent.
Experts say that while there is no demand issue for short-term bonds and they have done well, there has been a decline in demand for medium- and long-term bonds, which had an impact on its performance.
“The medium- and long-term duration bonds have not performed on account of various factors including lack of demand for the bonds. This is the first time in almost four years that incremental FII buying did not happen and even RBI has not done open market operations purchase. Further, over the last three months there have been negative sentiments on account of Bihar poll results, concerns over US Fed meeting and inflation concerns on account of recommendations of the 7th Pay Commission,” said Amit Tripathi, CIO, Fixed Income, Reliance MF.
While an adverse Bihar election result for the BJP-led NDA raised concerns that the government at the Centre may take populist measures, the recommendations of 7th Pay Commission are expected to be inflationary in nature and they raised concerns.
There are others who feel that even the currency volatility and strengthening of dollar has played a role in keeping the markets wary and resulted in underperformance of medium- and long-term duration bonds.
Even as there are concerns over transmission of previous rate cuts and the timing of future rate cuts by the RBI, industry players and investment advisors see an improvement in the performance of medium- and long-term bonds and advice investors to stay put with their investments.
“I expect the demand situation for bonds to improve going forward. While the FII additional buying did not happen this year, the RBI, in September, allowed FIIs to purchase additional bonds amounting to Rs 15,000 crore in a quarter and that should result into additional demand of Rs 60,000 crore for bonds in a year. Also the spread between overnight rate and the 10-year G-Sec bond is high and that raises hope for better returns in future,” said Tripathi.
Others, too, feel that the market will see the transmission of previous rate cuts and it is just a matter of time. “The debt story is not over. While existing investors may have not got the benefit of the RBI rate cuts, they should stick to their investments as the market would adjust for the same, though, with some lag,” said Surya Bhatia, a Delhi-based financial planner.
Even as various uncertainties remain in the market, Goswami, too, expects an improvement in performance of debt funds. He said, “We believe that the medium- and long-term duration bonds look attractive for investment and are comfortably placed as far as risk adjusted return is concerned given the fact that the margin of safety is high.”
The other concern is a possible delay in further rate cuts by the RBI that may have the potential for bettering returns for investors. With recommendations for hefty salary hike for Central government employees and pensioners there are concerns over a rise in inflation and that may result into the RBI further deferring interest rate cuts. Bhatia, however, said that even though the rate cut may come with a lag, they should come and hence investors will benefit. “Any further rate cut by RBI will be well thought through and it may also get deferred. In such a case, investors will have to bring down their expectations from debt funds in the short-term. Further, a hike in rates in the US may impact demand for bonds in India,” said Bhatia.