What next for short-term bond funds?

Reserve Bank's rate pause does not signal a rate reversal. Stay invested in these

If you are tempted to park your money into long-term bond funds only because the Reserve Bank of India (RBI) has not raised key interest rates, hold on for now. Experts say this is merely a pause in the rate hike cycle and does not signal a reversal of the interest rate cycle. Investors should, therefore, continue to remain invested in short- and ultra-short term bond funds.

The 10-year G-sec eased to 8.78 per cent (13 basis points) on the good news that rates were not raised. However, interest rates could go higher, depending on how inflation pans out in January. Says Lakshmi Iyer, chief investment officer (fixed income), Kotak Mutual Fund: “The recent rate increase is just a pause. It’s not a given that RBI is going to  or not going to raise rates in the next policy.”

But at the short end of the market, the liquidity in overnight money markets has been very good and yields are mirroring the repo rate. That’s expected to benefit short-term bond funds. Given this comfortable liquidity position in the banking market, experts say open market operations at this stage are unlikely. On the contrary, interest rates in the short-end of the yield curve could soften, likely to result in bond gains for investors in short-term funds.

Says Dwijendra Srivastava, head of fixed income, Sundaram Mutual Fund: “As a predominant part of the fixed income portfolio, short-term debt and liquid funds are a good place for investors to remain invested. There are still a few key concerns like the tone and quantum of tapering and the general elections, therefore, one should not take a duration call right now.”

At the longer end of the yield curve, the 10-year G-sec yield is likely to remain choppy, as inflation is still high. The RBI attributes the recent rise in inflation data to a rise in vegetable prices, which could come-off with a new crop coming in. However, how inflation will play out remains to be seen.

Says Iyer: “It’s not a given that the RBI is going to or not going to raise rates in the next policy.”

Long-term bond and gilt funds that took a knock as yields were rising could gain in the coming weeks as yields ease. But experts say investors should still not look at this category for now. Srivastava feels there could be more event-related uneasiness at the long end of the yield curve, as inflation and fiscal deficit numbers and election-related issues could keep volatility high here. “One should avoid duration funds for now but if one does want to get into long-dated bond funds due to better yields, invest very slowly and in a staggered manner,” says Srivastava.

At the longer end even a small increase in interest rates could send bond funds’ net asset values plunging. Bond prices move in the opposite direction of interest rates. If the interest rates come off in the latter part of 2014, as is expected, long-term bond funds could make hefty gains. In the near term, though, choppiness is expected to remain high in 10-year G-secs. So, it’s best to avoid long-term bonds ups and downs for now, and stick to short- and ultra-short term debt funds.