Long duration bond funds not for everyone

The top performer in the debt category in 2014, they are expected to do well due to expected rate cuts

Retail investors, even those who have invested in debt mutual funds, haven't had it too bad in 2014. With average returns of almost 16 per cent for the one-year category, these schemes have been the top performer in the debt segment this year, according to Value Research data. And expectations of a benign interest rate environment in the coming year might help them to perform better in the coming year as well.

Fund managers have already started increasing the maturity of their papers.

But to get best results from your debt investments, remember to stay invested for at least three years.

The reason: Under new tax laws, you will be taxed at the rate of individual slab, if you withdraw before three years whereas after three years, you will be taxed at 20 per cent with indexation. The inflation indexation benefit is substantial.

There are two kinds of benefits from bond funds - gains from interest income and capital appreciation.

The longer the holding period, the higher the contribution of interest income to the total returns, according to R Sivakumar, head - fixed income, Axis MF.

Interest rates and bond prices are inversely proportional to each other. When interest rates fall, bond prices rise and when interest rates rise, bond prices fall.

In the current scenario, with interest rates expected to decline, duration funds should do well.

The biggest risk of investing in these schemes is high volatility.

"Long-duration bond funds are more volatile than short-term bonds. So, the longer one stays invested, the easier it is to ride out the volatility," adds Sivakumar.

Due to this volatility, experts advise that while these instruments are good for the portfolio, limit the exposure to 10-15 per cent. "Retail investors should not allocate aggressively to these funds," said Hemant Rustagi, CEO, WiseInvest Advisors.

The biggest risk with investing in such funds is that the interest rate cycle might not play out as expected.

Analysts have been expecting the Reserve Bank of India (RBI) to cut rates for the past one year now, but the central bank has maintained a status quo.

"If interest rates do not fall, or if the rate cut is not to the extent as it is being anticipated, one can expect volatility to increase in these funds," adds Rustagi.

In the past, fund managers have caught on the wrong foot by the apex bank.

Last July, several fund managers had increased the average maturity period of their long-duration funds, anticipating a fall in interest rates.

However, the strategy backfired, as RBI unexpectedly raised interest rates as part of its liquidity tightening measure and returns of some income and gilt medium- and-long-term debt funds declined three-four per cent on a single day.

Those who want to invest in long duration funds now would do well to remember that bond funds have already gained quite a bit in anticipation of a rate cut. Long duration bond funds have emerged the top performers among debt funds this year. According to data collated from Value Research, income funds and Gilt Medium & Long Term funds have given 1-year average category returns of 12.6 per cent and 15.9 per cent, respectively. The yield in 10-year government papers has fallen to 7.955% from 8.825% at the end of last year.

Global factors, however, may halt the bond party. For example, if the US dollar continues to strengthen against the INR, it could indirectly impact interest rates. This is because if the rupee weakens considerably against the dollar, the RBI will be forced to sell dollars. This will suck out rupees from the system, resulting in tightening of overnight and eventually long term interest rates. Our bond market could also come under pressure if the US Fed decides to raise interest rates more aggressively than expected.

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