The current macroeconomic situation seems to have tilted the scales in favour of a lower interest rate regime and investors in long-term debt funds stand to gain the most from this. Let us understand step by step the present environment and why investors will do well to add duration to their debt holdings.
Fact 1: The Reserve Bank of India signals changes in its policy with a 25 per cent reduction in the repo rate.
Fact 2: Interest rate structures are being dismantled everywhere; deposit-taking institutions have started to scale down their offers, leaving fixed-returns investors in a quandary.
Once we have taken into account the above facts, we can reiterate a well-known homily, commonly heard in the debt market these days - income-fund investors need to rework their strategies to take advantage of the emerging trends.
As the latest figures indicate, inflationary pressures (measured in terms of the consumer price index) on the economy have reduced. There is now room for a definite shift in the RBI's monetary policy stance, evident from its most recent move on SLR. The simple point is further rate cuts may well happen in the future.
Hence, debt market participants may be staring at substantial changes in market dynamics. Those who approach the market through mutual funds should be aware that long-term debt funds are now likely to yield higher growth.
At the heart of this assumption is the easing of rates, which has particularly helped funds with substantial allocations to gilts (that is, government securities) and other select instruments. With yields and prices going in opposite directions, investors stand to benefit from their gilt holdings.
There is a whole assortment of debt funds to choose from. The selection will depend, among other things, on an investor's time horizon. Today, we shall focus on funds which require longer strategic calls.
The current market situation would have a bearing on investors' choice for long-term funds. The more discerning among them are aware that interest rates would keep on declining, which should result in growth for even the ordinary participant.
Now, a shift in interest rates usually has a greater impact on funds with long-duration portfolios. Gilt funds, which invest in debt securities issued by the government, can be risky from that point of view. However, the possibility of big returns in specific circumstances is also quite high in their cases.
Medium and long-term gilt funds have generated a one-year average of 17 per cent as on January 23, 2015. They have outstripped plain-vanilla income funds that have delivered less than 14 per cent return during the same period. Naturally, short-term debt products have yielded much less in the last 12 months.
If you are not sure about your exact needs, consult a financial planner. The idea is to choose funds that suit your risk appetite, keeping in view your specific needs. Before that, you may do your own homework - check fund factsheets and examine portfolio compositions as well.
Keep taxes in mind
Taxes, just like inflation, will eat into the appreciation recorded by debt funds. Under current tax regulations on capital gains, any investment with a holding period of less than three years will attract a short-term capital gains tax.
This will be a challenge for many investors. Let's presume that the existing interest rate structure is likely to undergo regular changes. If this happens, a longer three-year stance may not be so beneficial for all.
Taxes add to investors' worries, including the risk of default. The issuer of a debt instrument may fail to pay the interest and repay the principal. Thus, most investors find comfort in higher credit ratings. Debt funds invest in several kinds of instruments, ranging from the relatively risk-free (such as gilts) to high-risk papers (such as ones issued by corporates).
Three years, given the tax considerations, is a critical stretch of time for debt funds. It is quite difficult to predict the interest rate situation after three years. In the emerging scenario, therefore, debt fund investors can adopt a flexible stand with regard to their holdings. The following strategy may help them to maximise the potential of the debt market
• Never forget the risks: Debt funds carry their own set of risks. As returns go up, the possibility of losses owing to higher risk also increases.
• Book profits regularly: Profit-booking is not the sole preserve of the equity investor - yet such an image is somehow fixed in our minds. Debt fund investors, too, should regularly take home profits if the circumstances are right.
• Make calculated moves: Investors may make fresh allocations to gilt and other medium-to long-term funds if they are confident about the risks. This may involve diluting other holdings or exiting safer modes of investment. If you are risk-averse, just stay invested in conservative alternatives, such as short-term funds.
Debt fund investors need to appreciate the diverse range of products present in the market today. The value of their portfolios will largely depend on interest rates. These funds tend to gain in value as the rates decline. The inverse relationship between interest rates and debt prices is now at work. It's time to gain from it.
The author is director, Wishlist Capital Advisors