Bonds may outperform gilts over 12-15 months Perception for real

Debt mutual funds can replicate their recent performance and the outlook on interest rates does remain bullish for bond funds, asserts Ms Lakshmi Iyer, Head of Fixed Income/ Products, for Kotak Mahindra AMC.

Excerpts from an interview:

Debt mutual funds have seen a sharp increase in one-year returns. Your income fund, Kotak Bond Fund, generated 14 per cent in a year. Can such returns be replicated the coming year?

I remain quite optimistic about this! The rally in the gilts market has had a deferred impact on the corporate bond segment. And as such, significant rate-spread continues to exist between gilts and similar tenure corporate bonds.

This rate-spread is bound to witness a compression as bond yields decline further to match up to the historical average gap.

In that context, I remain upbeat that despite the near-term technical correction, the bond rally would continue for the larger part of 2009.

The high returns for the past year have been possible because funds such as yours have correctly caught the reversal in the interest cycle and increased their portfolio maturity. Now that interest rate declines are factored in by the market, will returns slow down?

I think that market continues to anticipate an increasingly benign rate regime by RBI given the extent of the economic slow-down and the extent of credit infusion that is required to resurrect the economy.

So, I believe that there still remains some time before rates bottom out.

Further credit infusion into the markets would be necessary to cushion the moderating economy. That leaves good scope for bond/gilt funds to harness double-digit returns for their investors.

Between gilt funds and income/bond funds that invest in corporate bonds, which option should an investor go in for now?

The rally in the debt market is widespread and envelops a wide range of securities.

This intrinsically enhances the return potential of both long-term gilts and bonds.

But over a 12-15 month time-horizon, bonds may outperform gilts, given the sizeable rate arbitrage that exists now.

Are debt funds suitable for risk-averse investors, who otherwise prefer FDs? Debt fund NAVs have been quite volatile over the past few months, with a 16 per cent spike until January and a 3 per cent reversal thereafter….Does investing in debt funds also require a good sense of timing?

What you are referring to here is short-term volatility in NAVs, reflecting price sensitivity to yields. Frankly, the choice of debt funds over FDs is largely dependent on the time horizon and the investor’s risk profile. Yet, I would say that a debt fund would be a more tax-efficient investment choice in the present market.

Bond yields spiked sharply in February as the government announced its borrowing programme. Does the prospect of government debt crowding out private debt increase interest rate risk to your portfolios?

Yes, the high fiscal deficit and the consequently high borrowing programme does induce cause for concern. But I don’t think that it subverts the bullish market outlook.

Are you seeing any signs of a reduction in corporate bond spreads over gilts?

The spread on the said papers has narrowed down to around 300 bps from the 425 bps level in September-October. Going forward, further rate normalisation would be dependent on the macro outlook on the economy and business.

The current spread is indicative of the risk premium that investors are expecting and signifies widespread risk-aversion. I believe that, as the economic momentum picks up and the faith in the corporate performance is restored, spreads will come down to normal levels.

Should debt fund investors worry about credit risk in corporate bond portfolios at this juncture?

The credit quality of the portfolios across fund houses remains predominantly AAA. Kotak Mutual Fund’s internal investment framework requires a portfolio investment of ‘75 per cent and above’ in AAA bonds.

Of this, not more than 20 per cent originates from non-PSU entities.

Even within that, funds tend to avoid industrial sectors where the business outlook remains precarious despite a prime business rating. So we are quite comfortable about the credit risk inherent to our bond portfolio.