Duration funds in a spot over rate pause, yields hardening in past 6 months

Duration funds have had a rough run in the past few months. The pause in the rate-cut cycle has limited opportunities for these funds, which rely on duration play and primarily benefit in a declining interest rate environment. 

Over the past one year, the Reserve Bank of India (RBI) has turned hawkish due to the rise in global crude oil prices, possibility of fiscal slippage and rise in inflation. Yield on the 10-year government security is up 86 basis points (bps) to 7.28 per cent. In fact, g-sec yields are already discounting a 40-50 bps rate hike by RBI. Bond prices and interest rates move inversely.

The assets of gilt medium & long-term funds have dipped 11 per cent to Rs 134.6 billion in the past year. On the other hand, assets of credit opportunity funds — a type of accrual funds — have grown nearly 45 per cent, to Rs 1.11 trillion from Rs 768 billion, data from Value Research show. 

Returns of duration funds have suffered as well. Gilt medium and long-term and income funds have become the worst performers in the past six months (see table). Liquid funds and ultra short-term funds have outperformed with returns of 3.2 per cent for the period. 

Experts believe bonds still look attractive and yields can ease from current levels if the RBI addresses demand-supply issues. “Measures such as temporarily cutting the maturity profile of government bonds will help. This will also encourage banks that have suffered losses on their bond portfolios in the past three-four months owing to the spike in yields, to invest in government securities,” said Dwijendra Srivastava, chief investment officer-debt, Sundaram Mutual Fund.  

Within the fixed income space, one could allocate 10-20 per cent to long-term bond funds in a staggered manner and the rest to accrual products, feel experts. The allocation could be higher if the investment period is longer and especially if yields climb above 7.5 per cent. “Investors looking to park their money for the next 12-14 months should look at short-term bond funds for the next six to eight months. However, one should not ignore long-term bond funds completely,” said Srivastava.