Rising yields, exposure to IL&FS' shrinking returns hit debt funds

Yields of 10-year government papers have surged 115 basis points to 7.91% , from 6.76% a year ago

Debt funds have had a poor run over the past year with the spike in yields and some schemes' exposure to IL&FS’ shrinking returns.

Liquid and ultra-short term funds emerged the top performers, with one-year returns of 6.7 per cent and 5.8 per cent, respectively. Dynamic and long duration funds, on the other hand, were at bottom of the pile, with returns of 1.7 per cent and 1 per cent, respectively, shows data collated from Value Research.

“The biggest factor has been duration; funds with the least duration have done reasonably well whereas long-duration funds have suffered from the spike in yields," said Vidya Bala, head of mutual fund research at FundsIndia.

Bond prices and yields are inversely proportional - as prices increase, yields fall. The Reserve Bank of India (RBI) has increased rates by 50 basis points in the past one year.

The RBI opted to maintain status quo in its policy meeting on October 5, which has brought some relief on the interest rate front.

"Given the status quo, we expect short-term rates to ease while long-term yields may trade range bound. The macro needs monitoring, and rupee and crude oil prices could lead the way for markets going forward," Lakshmi Iyer, CIO (debt), Kotak Mahindra Asset Management, had said in a note after the policy decision.

Yields of 10-year government papers have surged 115 basis points to 7.91 per cent, from 6.76 per cent a year ago.

The exposure to IL&FS, on the other hand, had a greater impact on the shorter tenure funds. Some fund houses had taken significant exposure to debt papers issued by IL&FS and its subsidiaries. These schemes had to take a sharp haircut on their exposure, following the multi-notch downgrade of parent IL&FS. As these markdowns impacted net asset values of the schemes, investor returns were also hit.

The tight liquidity environment made it difficult for MFs to offload commercial papers of duration as low as one or two days. Some large fund houses even borrowed from banks to meet the incremental redemption requests last month.

Total assets under management of the MF industry shrunk to Rs 22 trillion in September Rs 25.2 trillion at the end of August. Most of the damage was due to record outflows from liquid and fixed income schemes, in which large investors invested. The two categories saw outflows of Rs 2.4 trillion in September - the most since at least January 2008.

In addition to the quarterly phenomenon of high redemption related to advance tax payments, the tightness in money markets and continuous rise in yields also added to outflows, according to ICRA.

“The losses for accrual funds are mark to market. As long as investors hold their short term debt schemes for the duration for which they entered, they will not lose out. Long term funds, however, will continue to remain under pressure unless the interest rate cycle turns,” said Bala.