US Treasury Yield Spike: Does It Make Sense to Invest in International Debt Funds?

October 21, 2023 Mutual Fund

The US benchmark 10-year treasury yield has surged to its highest level since 2007. This has driven some mutual fund houses in India to launch International debt mutual funds focusing on the US Treasury bond market.

In February 2023, Bandhan Mutual Fund (erstwhile IDFC Mutual Fund) launched the industry’s first international debt fund. The scheme, Bandhan US Treasury Bond 0-1 Year Fund of Fund, offers exposure to 0-1 year US treasury bonds.

Additionally, Aditya Birla Mutual Fund’s two ongoing new fund offers (NFOs) also aim to invest in the US bond market. The Aditya Birla SL US Treasury 1-3 Year Bond ETF Fund of Fund is focused on US treasury bonds having maturity between 1-3 years, while the Aditya Birla SL US Treasury 3-10 Year Bond ETF Fund of Fund is focused on bonds that mature in 3-10 years.

Why are US bond yields rising?

The US treasury bond yields have been steadily rising in the last one year. The 10-year bond yields have climbed up to a multi-year high of close to 5% from around 1.7% at the beginning of the year 2022. The shorter 1 year, 2 year, and 5 year treasury bond yields too have been surging.

US treasury bond yields have surged to multi-year highs

Data as of October 19, 2023
(Source: ycharts.com) 

The US Federal Reserve has been consistently hiking interest rates to tame stubborn inflation levels and widening fiscal deficit. It has cumulatively hiked rates by 525 basis points since early 2022. As the new bonds were issued at higher interest rate, the value of older bonds declined. The resultant lower returns on investment triggered a selloff in the long-term government bonds. It is important to note that bond yields and prices are inversely related, when bond yields rise, their prices decline, and vice versa.

And as the US Federal Reserve continues to maintain a hawkish stance, investors expect that higher interest rate may continue through 2024, accelerating the surge in yields.

Notably, the US has avoided recession for now. Its growth has been better than expected on the back of resilient job market. This has also made a case for continuing monetary tightening. Thus, the interest rates may stay higher for longer, resulting in surge in yields.

The US yields are still lower than what Indian government bonds offer. However, the yield spread has shrunk steeply from around 500 bps in 2022 to around 240 bps.

Can debt fund investors benefit from investments in US bonds?

The international debt funds currently available in the market track the high quality US treasury bond yields. This makes relatively low credit risk investment avenues. As per Standard & Poor’s assessment, the US sovereign debt enjoys AA+ rating, making it a very high quality asset, compared to India’s BBB- rating.

The Fund of Fund (FoF) route offers a convenient way to enter the US market compared to the traditional Liberalised Remittance Scheme (LRS) mode of investing in the US market due to the non-applicability of Tax Collected at Source (TCS) and the absence of capping value.

International debt funds also offer diversification opportunity for debt portion of the investment portfolio. According to Vishal Kapoor, CEO, Bandhan Mutual Fund, investments in US bonds opens up a brand new asset class for Indian investors because so far international investing was largely focused on equity investment.

He also added that investing in international debt fund may help investors build assets for various goals such as children’s education abroad, or for those looking to vacation abroad, or other such overseas goals.

Thus, investors in international debt funds may benefit from geographical diversification.

Investors may also benefit from the currency front as international investments can shield the portfolio from depreciation in Rupee. In case of Rupee depreciation, investors may likely get a boost on their overall returns from debt investment.

Additionally, if investors prefer the shorter duration debt mutual fund schemes, such as 0-1 year and 1-year, they can benefit from low volatility and low interest rate risk. Shorter duration investments also offer visibility on returns expectation compared to longer duration bonds.

Meanwhile, investors with longer horizon can consider funds with 3-10 year maturity. This will allow investors to lock in investment at elevated yields for extended time period, and thereby benefit from higher potential for capital appreciation when interest rates trend lower in the future.

What are the risks involved in international debt fund investment?

While the US treasury yields carry low credit risk, there may be interest rate risk and duration risk. Though the yields are currently elevated they are subject to change (may be higher or lower) in line with dynamic market environment such as inflation levels, interest rate cycle, economic growth, central bank actions, government debt, and so on. The impact is likely to be prominent in the case of debt funds that invest in longer maturity bonds, while shorter maturity bonds witness minimal impact.

Another risk factor is currency movement of the Rupee vis-a-vis US Dollar that may impact the returns for domestic investors. During certain phases such as when the Rupee appreciates, the returns may not be attractive enough.

How are international debt funds taxed?

International debt funds are treated on par with domestic debt mutual funds for taxation purpose.

For resident, as per section 112 of the Income Tax Act, long-term capital gains on redemption or transfer of units (after a holding period of 3 years or more), are liable to tax at the rate of 20% (with indexation benefits). Base year for indexation for computing long term capital gains is considered as April 01, 2001 or the year in which the asset was first held by the assessee, whichever is later.

Short-term capital gains arising on redemption or transfer of units (after a holding period of less than 3 years) are subject to tax at normal tax rates applicable to investors.

What should investors do?

International debt funds that focus investment on US treasury yield carry low credit risk. However, one cannot ignore the interest rate risk, duration risk, and currency exchange rate risk as it can lead to fluctuations in the portfolio and impact the overall returns. Investors must understand all the associated risks before taking an investment decision.

Investors must take into consideration their investment objectives and select the suitable schemes for the portfolio. Also, prefer investing in schemes with suitable maturity period such that it aligns with your investment horizon. This will investors to mitigate the impact of market fluctuations on their portfolio, thereby enabling reasonable risk-adjusted returns.

This article first appeared on PersonalFN here