Debt fund returns are muted for now, but as and when the interest rates stabilise, you will get better returns, driven by portfolio accruals. Hold on for now
In our April 2022 issue, we discussed the requirement of adequate holding period in debt funds for achieving optimum returns. That’s because, while there is a steady accrual in all debt funds, transient market movements can take away from, or add to the accruals in the portfolio.
Current Situation Of Bond Funds
Over the last one year or so, returns from debt funds have been muted because yield levels (interest rates) in the market have been moving up in anticipation of rate hikes by the Reserve Bank of India (RBI). The central bank has now started hiking rates, and, consequently, yields are moving up further. RBI’s rate hike cycle will continue now, maybe, for a year or so. Hence, for the next one year, the impact of market movement of interest rates is going to be adverse. This means that while accruals in debt funds will happen as usual, the mark-to-market impact will take away a bit from your returns.
However, there is a positive aspect to it, which tends to get missed out in the shadow of muted returns. The accrual levels of debt funds have been moving up along with rising interest rates in the market.
How does it happen? The daily computation of the net asset value (NAV) happens at the yield level prevailing in the market, as given by the designated agencies. When bond yields in the market are moving up, i.e., prices are coming down, the yield-to-maturity (YTM) of the portfolio, which is the valuation yield level, moves up. The coupon rate of instruments in the portfolio do not move up automatically, but as and when instruments mature, the face value comes back, and the portfolio gets a kicker. Subsequent investments happen at a higher yield as well.
Over the last year, as and when the portfolio YTMs of debt funds have been moving up along with rising interest rates, dropping bond prices have been eating away from the returns you would have otherwise earned from the accrual. So, when do you benefit from rising yields or interest rates? The answer is when the interest rates stabilise. When rates stabilise, adverse market movement does not take away from your accrual. Did you think that exact steady-state yield or interest rate in the secondary market for bonds is not possible? Well, as long as the impact is minimal, you will earn better returns driven by better accrual levels.
Let us take an example for clarity. Let us say, there is a debt fund with a portfolio YTM of 5.50 per cent, and recurring expenses of 0.50 per cent. Hypothetically, if interest rates in the market were constant, you would have got 5 per cent return over one year, net of fund recurring expenses. Now, let us say, the portfolio YTM moves up to 6.25 per cent. In this situation, how much return do you get? The accrual of 5 per cent is there in the portfolio any which way. But there is an adverse impact of yield level moving up on the bond price. The gauge for this impact is modified duration (MD) of the portfolio. The impact is gauged using MD as the multiplier on the market movement of yield level. Since yield level has moved up by 0.75 per cent (6.25-5.50), if the MD of the portfolio is 1, then the ballpark estimate for return over last one year is 5 per cent minus 0.75 per cent x 1 = 4.25 per cent.
If the MD is three years, then the estimate for last one year’s return is 5 per cent minus 0.75 per cent x 3 = 2.75 per cent. This is just a ballpark estimate, as duration of the portfolio does not remain constant, and yield movements in the market happen in a zig-zag manner.
But this gives us some clarity on why returns have been muted over the last one year. Because of lower interest rate, the yields were lower.
What about the next one year? Now, in our example, portfolio YTM is 6.25 per cent. Net of fund recurring expenses of 0.5 per cent, the investor should get 5.75 per cent (6.25-0.50) over the next year or so, based on accrual. But that is not to be, as RBI is hiking interest rates. Hence, it all depends on to what extent the market reacts to actual and potential rate hikes by RBI, and how much yield levels move up.
For our illustration, let us say the yield level moves up by 0.5 per cent. On a similar plane as earlier, if the portfolio MD is 1 year, the next one year’s return is expected to be somewhere around 5.75 per cent minus 0.5 per cent x 1 = 5.25 per cent. If the portfolio MD is three years, then the estimate for next one year’s return is approximately. 5.75 per cent minus 0.5 per cent x 3 = 4.25 per cent. Net-to-net, it is expected to be better than last one year. The accrual is better any which way. As long as the market yield movement is less adverse over the next one year than last year, you are that much better off.
Market Expectation Over Next One Year
Projecting market movement over the next one year is anybody’s call. That said, we need to have a perspective on our investments. RBI will hike interest rates for sure, as inflation is on the higher side, and RBI has a mandate to fight inflation by tweaking interest rates. The saving grace for debt fund investors is that the market has already reacted a lot to actual and potential rate hikes. For instance, the 10-year benchmark government seurities (G-Sec) yield touched 5.75 per cent in May 2020. Around June 10, it was at 7.5 per cent, having moved up significantly. Prior to the surprise interest rate hike on May 4, 2022, the 10-year yield was little more than 7 per cent. It has moved up by approximately 40 basis points (0.4 per cent), whereas RBI has hiked repo rate by 90 basis points (0.9 per cent). Going forward, a similar phenomenon is expected; while RBI hikes interest rates, G-Sec yields will move up, but not as much. The one-year corporate bond yield, which is approximately. 6.5 per cent today, was approximately 4 per cent one year ago. This gives us a perspective that so much is already there in the price, i.e., in the market level. Hence, over the next one year, as RBI will hike the rates, the market will react, and the yield levels will move up, but the reaction will not be as much. That is, yield levels would move up to an extent that is less than RBI rate hikes.
Conclusion
The net message here is that don’t exit your debt fund investments looking at last one year’s muted returns. As illustrated above, portfolio yield levels are better than earlier. While there will be some more upward yield movement over the next one year or so, it is important to hold on. Portfolio yield levels will improve further. Thereafter, maybe, after one year from now, the market will stabilise (relatively, compared to current times). Then you will get better returns, driven more by the portfolio accruals than market movement.
The writer is a Corporate Trainer and Author