Watch out, debt funds could become attractive…

Back in the period 1999-2001 the then RBI governor, Dr. Bimal Jalan, had embarked on a massive interest rate cutting spree. Back then rates used to be exorbitantly high; in fact some of the bonds issued by IDBI and IFCI during the mid nineties carried yields of 16-18%. When the RBI started cutting rates many of these high yield bonds started seeing price increases. This is normally the way bonds behave. When interest rates fall then the prices of bonds rises to compensate for the higher yield on the bonds. On the other hand if interest rates rise, then the bonds see price depreciation.

Imagine what happened during 1999-2001…

This was probably for the first time debt mutual fund investors saw exorbitant returns on their bond fund holdings. This was something unheard off till then. As rates fell rapidly, some of the bond funds during the period yielded between 18-20% returns per annum for a continuous period of 3 years. We have not seen that kind of a bond bull market again in India, but it is instructive to understand the reasons behind the same. As interest rates fell, most high yield bonds started to see a sharp appreciation in prices. This directly translated into capital gains for debt mutual funds. High yield bonds were in demand and prices continued to go up on expectations of further cut in interest rates.

The impact is visible on government bonds and corporate bonds…

When rates are cut, the appreciation happens across bonds; be it corporate bonds or government bonds. The impact on government bonds is more visible as these bonds are more liquid in secondary trading as compared to corporate bonds. The result is that mutual funds holding corporate bonds and those holding government bonds tend to see an appreciation in their NAV when the interest rates are cut. Typically, bonds with a longer maturity tend to react more to movements in interest rates as compared to bonds with shorter maturity.

Are bond funds attractive once again?

That is now the million dollar question. Is it time to seriously look at debt funds and bonds funds once again? For too long the yields on these debt funds have been quite unattractive. Additionally, the tax treatment of debt mutual funds has generally been unfavourable compared to taxation on equity mutual funds. So what could change the scenario?

It may finally appear to be good times for bond funds as the RBI may embark on a rate cutting exercise. The RBI rate cut has two aspects to it. Firstly, there is the aspect of signalling by the RBI which is the easier part. The second is the actual transmission of lower costs which is also contingent on the cost of funds of banks and financiers. It now appears that the rate cut signals by the RBI may actually translate into lower yields and therefore higher bond prices.

Is it time for bond funds?

Bond funds consisting of government securities and private corporate debt may finally emerge as an attractive investment asset class. Indian rates are substantially higher than global rates and that rate gap needs to be filled up. It may probably be a matter of time when the RBI starts signalling lower rates with a view to making easier credit available for industry. The outcome may be a good period of debt mutual funds. For the last many years, retail and small investors have not found debt funds too attractive. If the government goes aggressive on rate cuts, we may see debt funds getting attractive once again. Probably, it may also see the return of retail interest in debt funds.

For all your mutual fund queries SMS ‘ASKMF‘ to 575758 and we will get back to you.

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