Which debt funds to hold now and other questions, answered

Debt funds are back to worrying many of you. Returns are dipping, there’s a lot of talk on yield movements both at home and in the US, there’s the question of where rates will head now. Over the course of the past several weeks, we have fielded several questions from you on what this means and what you should be doing with your debt funds.

We’ve written extensively on the developments in the debt space in different articles. But here’s answering the questions that appear to worry you the most.

Before we get to that, bear in mind the following points in debt funds – always.

• The first is that interest rates will go through cycles –rates will rise, rates will stay flat, and rates will fall.
• The second is that bond prices react to changes in the rate cycle. Bond markets do not wait for the Reserve Bank to raise (or cut) rates. Markets look for cues on rate direction – government borrowing, economic growth, inflation, credit standing of borrowers, exchange rates, global bond rates to name just a few. Bond prices fall (and therefore bond yields rise) when markets perceive a higher rate cycle or when rates actually rise and vice versa. Market perception of where rates are headed can sometimes be different from what the Reserve Bank is signaling.
• The third is that all bonds – government, corporate, PSU, bank – will reflect changes in interest rates. Some react more sharply while others see gentler moves. Broadly speaking, longer-term bonds see greater reactions and volatility than shorter-term bonds. Government instruments are more liquid and reflect rate changes more, followed by AAA-rated PSU and corporate bonds and then other papers.
• The fourth is that debt fund NAVs are a reflection of bond prices. So if prices fall, NAV falls. The extent of fall or reaction will depend on the maturity of the bond, the issuer, the credit rating, and the liquidity in the bond. But while prices change, the underlying bond continues to earn the coupon it did at the time the fund bought into those papers.

Now, let’s move to the questions.

Q I have a constant maturity fund in my long-term portfolio. Should I exit it and go for short-maturity funds?

Stay invested in these funds provided you hold it as part of your long-term portfolios (and you will take short to medium term losses) of at least 5-7 years.

Refer point 2 above. The reason you’re seeing lower returns now is because bond yields are moving up. To put it in perspective, the 10-year government bond yield went up from 5.89% at the start of 2021 to 6.2% now. We’ve already talked about the reasons why funds across the board are seeing dips in returns. We’ve also explained the relationship between yields and price, and how funds play the rate cycle in this article on duration strategy.

When you invest in gilt funds and constant maturity funds, you should be able to take return declines in stride. Low returns or losses in shorter-term periods are par for the course. Hre’s some data on how returns have panned out across rates cycles:

• Rolling 1-year returns of all gilt funds over the past 20 years shows that the funds slid into losses 5% of the time. Returns were below 5% about a quarter of the time.
• If we consider rolling 5-year periods, for the same 20 year period, gilt funds earned an minimum of 6.8% on an average.

Remember that interest rates also follow cycles. If your returns are low now because rates are rising, it can recover when the cycle turns back down. Holding for a long time allows these cycles to play out and the shorter-term ups and downs to even out.

This is why we always emphasize this:

• One, allocate these funds only to long-term portfolios.
• Two, do not take nil credit risk to mean nil losses.
• Three, avoid getting in because you’re seeing high returns expecting it to sustain. Remember we have seen almost 6 years of high returns in gilt as interest rates were on a continuous down cycle.

Gear up to see lower returns for a good while now in your constant maturity/ gilt fund. But know that there’s nothing adverse going on and this is a market cycle that you need to go through. Our Prime Fund recommendation in this space, and where we have such funds in Prime Portfolios continue to stand. Do note that in Prime Portfolios we have not even attempted to give such funds for portfolios below 7 years.

Q I am worried about the returns in my corporate bond & banking & PSU funds. Is it time to exit and move to short-term funds?

Again, go back to point 2, and the answer above. These funds are seeing lower returns now for the same reason. While they are accrual funds, the bonds they hold go through price changes based on rate cycles – see point 3 above and our explainer on accrual funds. You need to allow fluctuations to play out, and note that these funds are not aiming to make returns by timing the rate cycle. That is the ambit of dynamic bond funds alone. For corporate bond, medium duration and banking & PSU funds, remember that the underlying bonds that the funds hold continue to earn the coupon. Their range of duration is limited and therefore their falls are also not as intense as longer duration categories such as gilt or constant maturity.

Every debt fund has a minimum time-frame that you need to hold it for. When you change funds depending on where the rate cycle is headed and your returns, you will end up doing the following:

• One, exiting a fund without giving it the necessary time to perform (with the caveat that it is a quality fund). That may even mean booking losses.
• Two, exiting when your returns are down due to market movement and not fundamental poor performance on part of the fund. It is similar to booking out of equity during market corrections.
• Three, paying taxes which further cuts into gain. The same holds for your constant maturity/ gilt fund.

Q How low can returns go? What should I expect from my debt funds?

Well, returns can slide into losses as well. We can neither put a guaranteed number to it nor give you a timeline of when you can see recovery. Know that if you need a strategy change in any of our recommended funds, we will alert you to it. However, this article will help you set your return expectations in debt funds.

A popular measure many of you use is the portfolio YTM – theoretically speaking, YTM less expense will be the return you receive. However, your returns can be different from the YTM if the fund for reasons explained in the last part of this article.

Q If the rate cycle is moving up why can’t I switch to short-term space? Can’t I at least stop SIPs and redirect it to short-term?

Fair questions. But we’re not telling you to avoid investing in funds with short durations. All we’re saying is – don’t pull out of your existing investments in quality longer-term funds, when they are a part of your long-term portfolio.

When rates begin to rise, your fund is not going to completely miss out. The fund receives inflows, it receives coupon payments, it receives maturity proceeds all of which, will steadily be reinvested in higher-coupon papers. Since the fall in longer duration papers will be higher than the shorter ones, the ability of such interest payment to shore up NAVs will take time in longer duration funds. Short maturity funds are quicker to reflect rate changes in their portfolio yields than long-maturity funds.

When you hold the fund for the long term, you still stand to eventually benefit. Further, the longer maturity will help when the rate cycle turns back down, because the fund would have locked into higher rates for the longer term.

See the graph below, which shows the average portfolio yield-to-maturity (YTM) for different fund categories over the years. Yields move up when the rate cycle moves higher. For example when repo rate increased from 6% in August 2017, to 6.5% in August 2018, the graph below will tell you that YTMs moved sharply and was higher for medium duration funds than short duration ones.

To make good on the opportunities in the debt space now, invest surpluses, if any, in short maturity funds. Adding to such funds is something we outlined in our debt outlook for this year. Choose from funds in our ‘Very Short-term’ and ‘Short-Term’ buckets in Prime Funds.

As far as SIPs go, we do not recommend stopping and starting SIPs every so often in different funds as it adds to your portfolio’s complexity. In our view, if you’re running SIPs in corporate bond/medium duration/ banking & PSU/ constant maturity or gilt funds in your long-term portfolio, continue with it. In fact, for gilt or constant maturity funds, this period of lower returns is when you can get in a bit of ‘cost averaging’.

If you want to capture all debt market opportunities as and when they unfold, you can hold a combination of very short, short-term, longer-maturity and gilt funds in your portfolio. Essentially, you create a ‘ladder’ of different maturities in your portfolio.

Q Wouldn’t floater funds be the ideal funds to invest in, now?

Yes, floater funds at this time have an edge over other very short-maturity funds. But floater funds can see higher volatility, and need not all be very short-term in average maturity. Some funds may also bear higher credit risks if they invest in lower-rated papers. You need to be aware of these aspects before you pick a fund, and ensure that you have the right time-frame to hold these funds. We have two such funds in Prime Funds, and you can read a detailed analysis on the shorter-maturity of the two here.

But this doesn’t preclude you from opting for funds in the short-duration, money market, or ultra-short/low duration spaces. These categories are already beginning to see a rise in portfolio YTMs.

The easiest option would be to refer to the short-term Prime Funds categories. Because we look across categories for a particular time-frame, our recommendations would include the most suitable opportunities.

Q If I have a lumpsum to invest in debt funds, should I invest this in one go or should I invest through an SIP?

SIPs do not help much in debt funds, other than the slightly more volatile categories such as constant maturity or gilt funds. If you’re going for short-maturity funds, you can invest in one go; there’s no real need to stagger investments.

However, if you’re looking at target-maturity funds (and there are quite a few now), then timing is important as you need to lock into promising yields. Given that yields are rising now, waiting it out a bit could earn you higher yields. Therefore, you could divide up your surplus into at least 2-3 tranches to capture any uptick in yields.

Q Will you be re-rating or re-assessing Prime Funds and Prime Ratings based on the current interest rate cycle?

The methodology we use in Prime Ratings is designed to measure performance regardless of rate cycles. We rate funds within a category; the impact of a rate cycle change will be similar for funds within a category. Therefore, how well a fund navigates a rate cycle is always measured. This apart, it would be wrong to change the way we assess funds because a few categories are seeing volatility or low returns, while others are seeing an improvement in portfolio yields.

As far as Prime Funds goes, we provide you with a list of funds based on time frames rather than market timing. To this extent, we would still be recommending funds from different categories.

But we do look at the rate scenario when drawing up the list – we had a dynamic bond fund earlier, for example, before we removed it early last year as we preferred to be cautious in terms of where the rate cycle was headed. We’ve added floater funds, we’ve removed funds with higher credit risk and so on.

Therefore, where there are opportunities, we will certainly include them in Prime Funds. But we would rather that you focus on your ‘time frame’ than ‘market returns’ in debt funds. That is the only way to get less hurt in this space.

Q Should I invest in debt funds at all?

That’s your call 😊 More often than not, you’re complicating things for yourself by watching daily or weekly movements and fretting about whether other funds would be better options.

It is true that the debt space has seen events ever since September 2018 that make you question the need for debt funds. However, there are good reasons to be investing in debt funds – a major benefit is that they are by far more tax-efficient and liquid than other forms of fixed-income investments.

Please note that debt fund taxation has changed with effect from July 2024. Please refer to this article for updated tax rules.

You need to ensure three things:

• one, you’re in the right fund, and have the right timeframe for it.
• Two, that you do not try to squeeze the last drop out of your debt funds by always moving where returns appear to be.
• Three, you set your expectations right. Read the section on ‘Why are you in a debt fund’ in this article – a read to understand where you stand on debt funds.

Even if debt funds are meant to provide a hedge to your portfolio, we cannot rule out any adverse, unforeseen event wiping out returns. Or action the regulator takes to tighten rules in debt funds that have an interim impact. But as far as we’re able to spot risks arising, you can trust us to tell you when you should take action! We do keep an eye on credit risks, AUM changes, and rate cycle movements across debt funds.

If you fret about day-to-day movements, if you expect steady-state returns with no ups and downs, then debt funds may not suit you. You could instead explore options such as PPF/EPF, VPF (despite the tax impact from next fiscal, they still score on returns and safety) or other government instruments and bank/post office fixed deposits – all this if liquidity or  taxation are not key concerns.