In recent weeks, we have seen yields of government bonds rising. At the same time, government has reduced interest rates on many fixed instruments like NSC, PPF etc. This gives an opportunity to look into the fascinating world of debt mutual funds that can better post-tax return (Fixed deposit or debt mutual fund- What’s better?). While debt mutual funds can offer better post-tax return, one needs to choose them well. We wrote about broad framework for investing in debt mutual funds ( How to pick the right debt mutual fund). To know more about different types of debt mutual funds, refer to this article here.
Rising bond yield = low return by longer maturity debt funds
10-year Indian government bond yields have gone up by more than 100 bps (from 6.24% to 7.29%, 100 bps = 1%) since November 2016. Higher oil price, rising inflation and fiscal slippage are some of the reasons that are being ascribed to this sharp rise in bond yields. Oil prices are grinding up slowly and steadily. Whenever government borrows more than what it initially intends to borrow, it has to pay higher price and hence bond yields go up.
Now, whenever bond yields go up, the performance of existing bond suffers as bond prices decline. Longer the duration of the bond, more is the negative impact on prices of such bonds. This is reflected in the performance of debt mutual funds. Dynamic bond funds and short to medium-term government bond funds have delivered negative return over the last month. 1-year performance of such funds is also rather poor, delivering less than 5% return.
Have the bond yields peaked already?
Personally, I don’t think so. People have very short memory. I remember in 2013, bond yields troughed around 7.15% and from that level they rose sharply. It is true that India’s fundamentals have improved (reflected in stable currency and lower deficits). However, there are some risks. Over the long-term, Indian government bond yield should decline but in the near-term they are more vulnerable to news flow around budget, oil prices, fiscal deficits and government policies.
Which debt fund is suitable in current environment?
If one has investment time horizon of less than 1 year, it is better to go for liquid funds or ultra-short term funds. The yield to maturity of such funds is around 7% and after expenses (depending on the scheme), I expect they might deliver a return of around 6.5% over the next year. If I had investment time horizon of 3 years or more, I will look for slightly longer-duration bond funds. However, I will like to invest systematically over the next 6 months.
In last 1-year, liquid funds have delivered around 6.5%. Going forward, if interest rates rise, they can deliver at least 6.5%. If I am looking to invest for 3 years or more, I will prefer medium to long-term government bond funds. I don’t know if the bond yields have peaked already and hence to be more conservative, I will rather prefer SIP format to invest in medium to long deration government bond funds.
Disclaimer: The above content is just for information and should not be construed as an offer to buy or sell or recommendation. Contact your financial advisor for guidance on any investment related query.
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