Tilt towards long-income funds

As interest rates pause, duration funds look attractive again

Income-focused investors looking for some capital appreciation could revisit gilt and long-term bond funds. These funds took a big knock last year, when interest rates shot up suddenly, but are now poised to make big net price gains if the rate cycle starts to reverse.

One prime reason for the shift is the fact that the interest rate increase seems to have peaked. Last month, Reserve Bank of India (RBI) Governor, Raghuram Rajan, surprised the market by holding rates steady in the wake of high inflation. Now, with the key inflation rate, the wholesale price index (WPI), surprising on the downside, RBI is more likely to continue to hold rates steady for now.

The WPI declined to a five-month low of 6.16 per cent in December, compared to 7.52 per cent the previous month.  This should provide some comfort to RBI, which may consider holding the repo rate in its coming monetary policy review on January 28. Says Yadnesh Chavan, head-fixed income Mirae Asset Mutual Fund (MF): “The possibility of a rate increase is low in the next policy, and the RBI is more likely to hold rates for now.”

It will come as welcome relief for long-term bond funds. These funds lost as much as three per cent in the second half of last year on the rate increases. Currently, long-term gilt and bond funds have posted returns of only 3.1 and 5.4 per cent in the past year, according to data from Value Research, largely due to the distortion in the bond markets in July 2013. Says Lakshmi Iyer, senior vice-president and head-fixed income, Kotak MF: “If you look at bond returns pre- and post the July event, when all bond portfolios went for a toss, the returns are around the normal ranges.”

As normalcy slowly returns to the bond market, and long-term interest rates show signs of peaking, investor could consider switching some of their investments into long-term bond funds.  

However, those who parked money into less volatile short-term bond funds should incrementally begin to make that switch, rather than at one go. Says Iyer: “When the interest rates go down, long-term bond funds make higher returns. But you have to be very cognisant of the fact that there’s incrementally higher risk and investors should stay with a longer horizon.”

Also, experts say it be some time before we could see a reversal in the rate cycle. Since the elections are a major event, liquidity in the system still needs to be watched. Says Yadnesh Chavan: “Till there is some clarity on the fiscal side and since there’s a major event happening, investors can wait for some more time and assess the situation.”

So, even if starting now, experts say that begin with about 5 or 10 per cent in long-term bond funds. However, investors should be ready to play the duration, i.e. hold on for some time, and wait for interest rates to reverse, more likely to happen in the latter half of this year. That’s when investors should bag huge returns from long-income funds.