Invest in bond funds for the long term

These schemes are expected to perform in the next 2-3 years

After the Reserve Bank of India (RBI) maintained status quo on key rates on Tuesday, banks are beginning to indicate deposit rate cuts are round the corner, and this could be a sore point for risk-averse debt investors. However, for those willing to invest for the long term, the picture might not be bleak.

For such investors, experts recommend bond and income funds. “Investors might record double-digit returns from bond funds in the next year. The yield on the old 10-year bond is 8.86 per cent; the annualised returns are 9.05 per cent. A little decline in yields will generate good returns,” said Dhawal Dalal, executive vice-president and head of fixed income at DSP BlackRock Mutual Fund.

Bond yields and prices are inversely proportional.

Dalal suggests investors stay invested, saying in 12-18 months, they are likely to record good returns. According to data from Value Research, the returns of top performing pure gilt funds and income funds in the past year stood at 6-10 per cent, though not all funds have given such returns. The variance in performance is startling: the best-performing medium-and long-term gilt fund has returned 11.58 per cent, while the worst-performing has returned a dismal 1.14 per cent.

The returns are tepid because in July last year, RBI had resorted to liquidity-tightening to curb the sharp volatility in the rupee. This led to spiralling of bond (government and corporate) yields and lower returns. Though bond yields continue to be elevated, the rupee has turned and inflation is easing.

Consumer Price Index (CPI)-based inflation stood at 7.31 in June, against 8.28 in May. Economists say the fall is attributed to the high base of last year, owing to which RBI is taking a cautious stance on rate cuts.

Many fund houses are adding long-term papers to their portfolios, a sign they believe the rate rise regime is behind us. Financial advisors, too, seem bullish on these schemes. Suresh Sadagopan of Ladder7 Financial Advisories says while the trajectory RBI might take isn’t known, it is felt the central bank might either go for sharp cuts in interest rates or take a gradual approach. His advice: the investment horizon should be at least two years. In the Union Budget, changes were announced to the guidelines for tax incidence in debt funds. If one stays invested in these funds for more than 36 months, long-term capital gains tax 20 per cent with indexation benefits will be imposed. If these are redeemed earlier, the capital gains will be added to the income and the tax rate will be according to the income tax slab applicable.

Consequently, investors in the 10 per cent and 20 per cent income tax brackets can invest in bond funds, even if they wish to withdraw before three years. Investors in the 30 per cent income tax bracket should only invest the part of their portfolio they do not wish to withdraw in the next three years.