Debt funds are in a sweet spot

Re-calibrate your debt portfolio to take advantage of the high yields in the debt market

The good news is that the consumer price index (CPI) for February has eased to 8.1 per cent, the lowest since December 2011. The CPI is one of the key parameters used by the Reserve Bank of India (RBI) in determining domestic monetary policy.

Now, with the rate of inflation seemingly in check, will RBI cut interest rates in the coming months? Will long-term bond prices begin to rise? Should investors shift to long bonds? Fixed income investors should largely continue to stay with short-term bond funds. However, those with a longer horizon could start accumulating income and dynamic bond funds.

A lower rate of inflation means that RBI now has room to trim interest rates. Just last month, it had set a target of eight per cent for the CPI for January 2015. But the rate of inflation, as seen from the CPI, has already fallen sharply, from 11 per cent in November 2013 to 8.1 per cent now.

Experts say the rates may have peaked out. The 10-year bond yield is now hovering around 8.75 per cent, whereas paper with lower maturity is yielding higher returns with lower risk.

Experts, however, say the rate cuts are not likely to come anytime soon as the central bank may still toe a cautious line. Says Dwijendra Srivastava, head (fixed income) at Sundaram Mutual Fund: “We don’t expect to see lower interest rates just yet. The real rate of return is still negative for a country like India. Ahead, inflationary expectations are still high.”

Nevertheless, over the longer horizon of one-year, rates could head lower. Rising interest rates hurt bond prices, but falling rates can see big increase in bond values. Says

R Sivakumar, head of fixed income at Axis Mutual Fund: “RBI could take a more accommodative monetary stance in the next one year, especially with inflation coming down and that is good for bond funds in the long run.”

However, bond markets are more concerned about the elections around the corner and the policies likely to be implemented by the new government. Says Srivastava: “The market is more worried about a stable government. One has to remember it’s a month-long election; after which we have to see what fresh policies the new government will frame. And whether they are inflationary or otherwise.”

For now, investors should go about investing in long-term bond funds in a calibrated manner. The first quarter is volatile for bond markets. High corporate requirements, fresh issuances of paper, as well as a new 10-year benchmark are issued during this period. Says Sivakumar: “Investors could do an SIP (systematic investment planning) in the next three months in long-term bond funds due mitigate the volatility.”

Go slow in long-term bond funds and keep it to about 10 per cent of portfolios. This can be increased over time. However, investors should buy and forget these funds and avoid monitoring them as volatility in the interim could make one jittery.

Short-term funds are better placed. Investors should allocate a larger chunk - about 80 per cent of one’s debt corpus in accrual funds with lower bond maturities. The interest rates on these funds are inching closer to double digits, and they come with significantly lower risk. It’s a good time to remain in debt funds.