Here are the smart money moves debt mutual fund investors should make.
Review your debt fund portfolio
After a long period under the sun, debt fund investors should prepare for an extended winter. With interest rates at their lowest ever, the interest rate downcycle is on its last legs. This means the return profile of debt funds is likely to be very different in coming years. Do not remain anchored to the 8-10% return of the past two years. With rates bottoming out, bond yields have also crashed. By extension, yield to maturity (YTM) of bond funds has also moderated—from 8-10% a few years ago to 5-7% or even lesser. This implies that these are not likely to fetch more than 5-7%—not including fund expenses— over the next few years. “For the same low-risk debt portfolio that you had earlier, your return expectation has to come down since the YTMs have come down,” insists Arun Kumar, Head of Research, FundsIndia.
Further, the softening interest rate regime that provided a leg up to bond funds’ return profile for the last few years is now over. This will keep a lid on bond prices and by extension, mark-to-market (MTM) gains in bond funds. It is best if you align your expectations to this reality. Pankaj Pathak, Fund Manager – Fixed Income, Quantum Mutual Fund, asserts, “At this point, investors should know that interest accruals on bonds have come down and potential for capital gain is also limited. So it would be extremely difficult to repeat the performance of the last 2-3 years.”
YTM across categories has moderated
Investors should expect much lower returns in coming few years
For the next few years, debt funds should purely be used from accrual perspective rather than for MTM gains. Maneesh Dangi, Head – Fixed Income, Aditya Birla Sun Life AMC, says, “Pure duration gains are largely behind us given that policy rate trajectory has bottomed out. Going ahead fixed income should be seen as accrual product or cash deployment strategy.”
Experts maintain that funds investing in high quality AAA rated bonds in the 1-3 year maturity bucket provide a good space for parking money in the near term. “For 3-6 months allocation we would recommend low duration category and for more than 1 year horizon investors should look at short term fund category,” says Dangi. Corporate bond funds and Banking PSU debt funds also remain good options, but investors should not expect these to repeat recent performance.
Existing investors with accumulated gains may be tempted to lock in these gains now. However, with other fixed income avenues also yielding low returns, investors must consider how they will deploy the proceeds. If you don’t need the money in the next couple of years, stay put. While incremental yields will moderate in coming years, well-chosen bond funds will build upon accumulated gains. Besides, exiting funds held for less than three years is not tax-efficient. Any gains realised before three years will be fully taxed. Investors should stay put to get indexation benefits on capital gains that lowers final tax incidence.
However, given that the bond rally is nearing its zenith, investors may consider booking gains in certain pockets of the bond fund portfolio. This is particularly advisable for investments in long-duration or gilt funds, whose NAVs will see higher value erosion if the cycle turns.