Debt funds: Is an encore possible?

For those who turned active investors after 2004, debt funds as an option would have seemed least appealing, given the measly single-digit returns in contrast to the multi-baggers among equity funds. But as the tide turned on equity, debt funds have gained appeal with a good performance over the last year. A 28 per cent return by Canara Robeco Income or ICICI Prudential Gilt Investment PF was possible as result of the interest rate cycle turning decisively southwards.

However, given the steep rally witnessed in bond prices, especially in the quarter ended December, can debt do an encore this year? To gauge this, the factors driving debt fund returns have to be understood.

Since October 2008, when the RBI flagged off the first of a series of rate cuts, the yield of 10-year government securities, or gilts, declined rapidly to a low of 5.2 per cent from about 9.4 per cent (the year’s high) in July 2008. This unexpected reversal in interest rates triggered a sharp rally in the price of gilts.

To benefit from the declining yields and rising bond prices, a good number of gilt funds increased the average portfolio maturity. For instance, ICICI Pru Gilt Investment PF’s portfolio had an average maturity of 12.2 years in September 2008. The same sharply rose to 19.8 years as of January 2009. As longer maturity gilts tend to be more sensitive to rate changes than short maturity ones, funds that lengthened maturity profiles gained the most from the gilt rally. However, investors need to bear in mind that gilt funds with longer portfolio maturity also hold higher risks as they may correct sharply in response to interest rate spikes.

For instance the fund mentioned above fell close to 11 per cent on the back of a sharp and short rally in gilt yields in January. While there could be further interest rate cuts that could trigger bond price rallies, investors should be alive to the fact that a declining rate trend is already priced into bond prices, given that there is no longer any surprise element in the direction of interest rates.

Does this mean that the opportunity in debt funds is capped from here on? Not necessarily, for the following reason: Corporate bond yields have not seen as sharp a fall as gilt yields, as a result of the higher risk perception compared to safer government securities. Spreads, the differential in yields at which corporate bonds trade over completely safe gilts, are currently much above long-term averages. This being the case, a pick-up in credit to the corporate sector, an easing of risk aversion among lenders or a revival in the corporate sector’s fortunes could all trigger a corporate bond price rally.

This essentially means that a fund with a judicious mix of gilt and top-rated corporate bonds may hold higher potential for returns over a one-year plus period, rather than pure gilt funds. Investors with a higher risk appetite could consider such funds. Funds such as Canara Robeco Income, IDFC Dynamic Bond and Birla Sunlife Income Plus are some options.