Good days ahead for debt fund investors?

These funds have done well in recent times. If inflation is curbed and RBI cuts rates, you can expect good returns
Stocks have been in the spotlight following the BJP's landslide victory in the general elections. But even the debt securities have not done badly. In the past 3-6 months, debt funds have delivered handsome returns. A few long-term gilt funds have given more than 6% returns.That's nearly 25% returns on an annualized basis. This spectacular performance comes after a year of poor returns. The rise in bond yields have led the same long-term gilt funds to give very poor returns in the past one year.
But good news may be in store for investors if policy initiatives of the new government bear fruit. Experts say if inflation is contained, they expect the RBI to cut interest rates. “I would expect the new government's policies to drive down interest rates and, therefore, yields may come off by 100 bps in the next 12-18 months,” says Rahul Goswami, head, fixed income, ICICI Prudential AMC. If interest rates are cut, the value of the bonds in the portfolios of debt funds goes up, driving up their NAVs. Not everyone is so optimistic though.
Says Sujoy Das, head of fixed income, Religare Invesco Mutual Fund: “Interest rates are not yet conducive to support a turnaround in the investment cycle.
These will eventually come off, but there is still some time away. Lakshmi Iyer, head of fixed income & products, Kotak Mutual Fund, agrees: “An extended pause in interest rates is likely, as there are still looming concerns over inflation and a weak monsoon.”
Interest rate scenario If the various bottlenecks in the Indian economy are addressed, the growth scenario is likely to improve. However, experts reckon that it will take some time for the economy to open up. And, more importantly, interest rates will play a major role in shaping this recovery. Interest rates are still at elevated levels.
However, if things fall in place, as expected, a downward trajectory in the country's interest rates will be a reality soon. Says Das: “If the new government takes the path towards fiscal consolidation and the inflation figure is also supportive, then the central bank will surely start slashing the key policy rates.“ He says there will be a near 100 basis points cut in rates until the end of this financial year (March 2015). “The bond market has priced in the improvement in the current account deficit situation as of now. At current yields of around 8.8%, most of the bad news has been priced in, but hardly any of the good news has been factored in,” says Goswami.
Opportunity in debt funds This presents a big opportunity for debt fund investors. If investors choose wisely, debt funds could yield 9-10% returns in the coming year. The gains will be particularly strong in long duration bonds, which are more sensitive to interest rate changes. Says Das: “Long duration is where the action will take place.
The maximum capital gains will come through this basket when interest rates come off. Goswami, echoes similar sentiments: “We are overweight in the longer duration instruments from a medium to long-term perspective.” Investors could, therefore, start taking positions in income funds and even gilt funds, if they are looking t o invest for a 12-18-month period. However, for those looking at a time frame of less than a year, these funds may not be the best bet. If interest rates remain elevated for a prolonged time, then, obviously, long duration instruments will take a hit. That is why some experts, like Iyer, are waiting for some more clarity on inflation and government actions before recommending long duration funds. “Shorter duration accrual funds should find favour for the time being as these exhibit lower volatility and are less sensitive to rate changes,“ says Iyer. She says investors with a shorter investing time horizon should remain in short-term debt funds, while those willing to withstand higher volatility could opt for long-duration funds.
While the former will give stable returns, the latter could prove to be very volatile due to the changes in the interest rate scenario.