Debt Mutual Funds Returns: Here is Why Your Fixed Income Portfolio Is Likely to Perform Better
April 15, 2024 Mutual Fund
The RBI left the repo rate unchanged at 6.5% for the seventh policy meeting in a row in April. It has maintained its stance on ‘withdrawal of accommodation’ to rein in inflation.
The rationale behind this move was that, as per RBI’s assessment, the domestic economy is experiencing strong momentum. As per the second advance estimates of the government, the real gross domestic product (GDP) expanded by 7.6% in 2023-24 on the back of buoyant domestic demand. Real GDP increased by 8.4% in Q3, with strong investment activity and a lower drag from net external demand.
Inflation is also treading down, supported by favourable base effects. However, they continue to be above RBI’s medium target of 4% as uncertainties about food and crude oil price inflation continues to pose a challenge. Notably, the CPI inflation has been in the range of 5-5.5% in recent months.
In this scenario how is your fixed income portfolio comprising debt mutual funds expected to perform? Let’s find out in this article.
Where are the interest rates headed? And what does it mean for debt mutual fund returns?
While RBI will continue to be watchful about the inflation trajectory, the softening of core inflation and strong growth momentum may offer space for the central bank for interest rate cut. The common consensus is that the RBI will start rate cuts in the latter half of 2024.
With interest rates expected to come down going ahead, returns on debt funds are set to turn attractive.
Bond prices and interest rates are inversely related. When interest rates fall, debt mutual funds that invest in longer maturity securities tend to gain. Funds that invest in the short maturity segment witness minimal mark-to-market impact when interest rates fall.
[Read: What are Debt-oriented Mutual Funds: Meaning, Types, Benefits, and FAQs]
On the other hand, funds focusing on longer duration instruments that have an average maturity, typically in a range of 5 to 10 years, are highly sensitive to interest rate changes and tend to do well during stable and falling interest rate scenarios. However, these funds may face higher losses when interest rates are rising.
For instance, when the RBI cut interest rates in 2020 during the COVID-19 pandemic, long duration funds such as Gilt Funds generated double-digit returns. But when RBI began hiking the rates in 2022, the returns on these funds dropped to low single digits.
This happens because when the RBI lowers interest rates, the interest rates offered on new bonds issued will be naturally lower. As a result, older bonds with higher yields become more attractive. The prices of such old bonds inch up as investors are willing to buy them at a premium, leading to higher returns on debt mutual funds holding them.
Although there is a lack of clarity over the timing of the possible reversion in the interest rate, the peak in the interest rate cycle makes it an opportune time to invest in longer-duration debt mutual funds with a medium-term view of 2-3 years whereby you benefit from higher yield and unlock the capital growth.
Another reason why the yields may tread lower is that the government, during its interim budget, announced its decision to reduce borrowings in the fiscal year 2024-25. The gross market borrowings through dated securities during 2024-25 are estimated at Rs 14.13 lakh crore, 8% lower than the previous year.
The lower the supply of bonds, the lower is the yield. Since, the government is the major player in the bond market, its borrowings influence the direction of yield. When the government’s borrowing is lower, bond yields tend to be subdued. As a result, the interest rate on bonds issued by private players also treads lower which reduces their overall cost of borrowing.
The lower supply of government bonds too will work in favour of debt mutual fund returns as it will help in pushing down the benchmark bond yields.
Apart from this, the current fiscal year will see the inclusion of Indian government bonds in two global indices namely the JP Morgan Government Bond Index-Emerging Markets (GBI-EM) from June 2024 and Bloomberg Emerging Market Local Currency Government Indices from January 31, 2025.
The inclusion of government bonds in the global indices will result in higher flows into these bonds. Subsequently, the higher demand for bonds may result in reduction in yields on government bonds.
[Read: Best Debt Mutual Fund Categories for 2024]
What should investors in debt mutual funds do?
Returns on debt mutual funds appear set to turn attractive. However, one should remember that debt mutual funds are not risk-free and may be subject to interest rate risk, credit risk, default risk, etc.
Debt mutual funds, particularly those carrying longer maturity instruments, may witness higher volatility in the interim when interest rate fluctuates. Moreover, one cannot accurately predict the timing of rate cuts. On the other hand, shorter duration funds are less prone to interest rate fluctuations and thus offer better stability.
Thus, one must ensure that they select debt mutual schemes that aligns with their financial goals, investment horizon, and risk appetite. Remember that for a fixed income investor preservation of capital is paramount, returns are secondary.
For a medium-term investment horizon of 2-3 years or more, Dynamic Bond Funds, Banking & PSU Debt Funds, and Corporate Bond Funds may be suitable avenues, while Gilt Funds may be suitable if the investment horizon is 5 years or more. On the contrary, for an investment horizon of up to or less than a year, short term debt categories such as Liquid Funds may be suitable.
This article first appeared on PersonalFN here
