After giving mediocre returns during 2021-23, debt mutual funds in India turned attractive over the last one year and delivered high single-digit returns. Factors including significant FII (foreign institutional investors) inflows into Indian government bonds and expectation of a rate cut by the Reserve Bank of India have boosted investors’ sentiment.
Given that the bond markets have already rallied with the rate cut expectation priced in, here we look at whether there is still space for debt mutual fund schemes to deliver higher returns going ahead.
The change in RBI stance to provide respite to bond markets
The RBI’s monetary policy committee on October 9 left repo rates unchanged at 6.5 percent but changed stance to “neutral” from “withdrawal of accommodation”. Experts believe that the stance change reflects the RBI’s confidence on stable inflation going forward. This could open the door for policy easing in the upcoming monetary policy.
The RBI has maintained the repo rate at 6.5 percent since May 2023, following a series of rate rises. Despite this, the expectations of interest rate cuts have kept debt funds in a good position.
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The yield on 10-year Indian government securities fell by 70 basis points over the last nine months and currently trades at 6.78 percent.
Bond prices and interest rates have an inverse relationship; when interest rates fall, bond prices go up. This results in appreciation of the bond value that the debt funds hold which, in turn, leads to higher returns.
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Over the last one year, the long-duration bond funds, dynamic bond funds and gilt funds have delivered returns of 13 percent, 9.7 percent and 9.8 percent, respectively.
Increasing durations of the portfolios
All duration-based debt mutual funds increased durations of their portfolios remarkably over the last one-year period, expecting bond yields to fall further. Fund managers believe that debt funds stand to gain further when the rate-cut cycle starts.
Macaulay Duration (MD), which indicates the period a portfolio will take to repay your capital in terms of cashflows, is considered for this study.
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Deepak Agrawal, CIO, Debt, Kotak Mutual Fund, says, “Mutual funds have positioned themselves to take advantage of anticipated declines in interest rates much ahead of time. Mutual funds that anticipated rate cuts by the RBI proactively increased their duration, allowing them to benefit as bond prices rose with decreasing rates”.
Gautam Kaul, Senior Fund Manager – Fixed Income, Bandhan AMC, says, “Inflation has decreased in India and worldwide over the past year, which could lead to potential rate cuts. Furthermore, certain structural factors such as a low current account deficit, a decreasing trajectory of the fiscal deficit, an increase in savings allocation through long-term players like life insurance and pension funds, and the inclusion of Indian government bonds in global fixed-income indices have made bonds more attractive and in demand.”
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Many debt funds increased their durations by allocating higher to the long-dated government securities. For the last two years, debt funds have significantly piled up government securities in their portfolios. Devang Shah, Head Fixed Income, Axis Mutual Fund, says, “The demand-supply dynamics in government securities are very favourable due to fiscal consolidation, increased FPI participation and possibility of higher demand on account of change in banking LCR (liquidity coverage ratio) guidelines. Year to date we have received more than Rs 1.25 trillion of flows in government bonds. Inclusion in various indices such as JP Morgan, FTSE Russell EM index and Bloomberg EM index will lead to FPI flows trickling in the near term.”
With fiscal consolidation and strong growth, we believe the government bonds will outperform and expect spread widening for corporate bonds and state development loans, Shah adds.
Which debt fund segments are looking attractive now?
The longer duration bonds typically offer greater potential returns in a falling interest rate environment. However, a delay in the rate-cut decision could prevent further increases in returns.
Chintan Haria, Principal – Investment Strategy, ICICI Prudential AMC, says, “The Indian economy is currently in the mid-stage of its business cycle, where growth remains robust, and inflation is within the RBI’s tolerance levels. This suggests that policy rates are likely to remain in a narrow range in the near term”.
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Although global and domestic factors will continue to exert opposing pressures on yields, the medium-term outlook for fixed-income markets remains stable, Haria adds.
Shah believes there has been a significant rally in long bond yields hence incremental gains are expected with rate cuts. “Given our outlook for a shallow rate-cut cycle, investors can consider focusing on 5-year and longer-duration sovereign bonds,” Shah advises.
Notably, the 1–3-year corporate bond segment may become increasingly attractive following the initial rate cut, presenting potential investment opportunities, he adds.
Sandeep Agarwal, debt fund manager, Sundaram Mutual Fund, says, “The expectation of a rate cut has already been priced to a certain extent at the long end of the curve. Generally, when the rate-cut expectations begin to rise, the long-end rates fall sharply. However, the short and medium of the curve will perform better than the longer ends when the central bank actually begins rate cuts”.
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Currently, even though yields have declined, the yield curve remains relatively flat, says Agrawal of Kotak MF. The front end, particularly in the corporate bond segment, has not fully priced in potential rate cuts yet. This indicates that there could still be opportunities for growth across the yield curve, he adds.
The short end (1-5 year) is generally safer and less volatile, but it offers less upside compared to the long end, which may provide greater potential for capital appreciation if economic conditions improve, says Agrawal of Kotak MF.
“Long-duration funds and dynamic bond funds are expected to perform well once the RBI officially starts its rate-cut cycle, potentially by early 2025. Moreover, corporate bond funds focusing on high-quality issuers also offer opportunities,” says Nirav Karkera, Head of Research, Fisdom.
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