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2018: A Tough Year For Bonds?

It’s true that the recent spike in yields has dampened returns on bonds. But it is still a better option compared to fixed deposits

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Those who optimistically migrated away from the safe haven of fixed deposits into debt-oriented mutual funds in 2017 need to temper down their expectations now — experts aren’t exactly predicting smooth sailing for them in 2018. Kicking off the year at a relatively stable 6.4 per cent, the benchmark 10-Year G-Sec Yield, the key indicator of Indian Bond Price trends, has risen sharply to 7.1 per cent as on 11 December 2017. Longer duration debt funds have expectedly taken a beating, raising questions in the minds of uninformed or ill-advised investors who jumped in with both feet, falsely assuming debt funds to be devoid of risk.

Debt funds have gained in popularity in recent years. Data from the Association of Mutual Funds in India (AMFI) indicates that high networth individual (HNI) and retail investments in debt-oriented funds (besides GILT Funds) grew from Rs 1.92 lakh crore at the end of September 2014 to Rs 3.19 lakh crore at the end of September 2017.

The recent spike in yields seems to have caught even seasoned fund managers off-guard as most of them were unable to stay ahead of trends. This can be evidenced by the poor 1-year returns generated by a category of debt funds known as ‘dynamic bond funds’, in which fund managers actively take duration calls on the fund’s portfolio. Even the bellwether funds in this space failed to generate in excess of 5 per cent returns on an annualised basis this year.
“A combination of factors has been at work. Here at home, a bank bailout and expectations of fiscal slippage; and globally the rise of oil prices have resulted in worries about the trajectory of inflation and monetary policy. This has led to a rise in yields across the board,” says R. Sivakumar, head of Fixed Income at Axis Mutual Fund.

Tough Times to Continue
Mahendra Jajoo, head of Fixed Income at Mirae Asset Global Investments isn’t gung-ho about the first half of 2018 either. He believes with improving economic data across geographies, the US and other major developed market central banks such as the ECB are also likely to tilt towards neutral or tighter policies gradually in 2018. Burgeoning inflation coupled with the risk or fiscal slippage is also weighing on his mind.

“The recent tax reforms in the US, when implemented, may lead to landing back of large amount of capital into US at a time when the Fed is already shrinking its balance sheet and tightening global liquidity on an incremental basis. Domestically, inflation has seen a sharp rebound from recent historical lows, and is now likely to spike up to 4.5-5 per cent band by March ‘18. Fiscal deficit targets have come under scrutiny as revenue collections have not grown as strongly post GST (goods and services tax) as initially estimated,” he notes.

Given the multitude of short- to medium-term headwinds that lie ahead, bond prices are, at best, expected to be range bound in the first half of the year. On the other hand, if global oil prices were to rise further, global liquidity were to continue tightening, or Indian macros were to deteriorate further; yields may in fact continue to inch up, resulting in a further drop in bond prices across the board.

Your Strategy For 2018
Does this mean you should go scampering back to the safety and guaranteed returns of bank deposits in 2018? With rates hovering between 6 per cent and 6.25 per cent across most maturities, that hardly seems like a smart thing to do.

“Different investors have different risk and reward expectations. In addition, different investors have differing investment horizons. From a short-term perspective, our view on interest rates is neutral with a negative undertone,” says Killol Pandya, head of Fixed Income at Essel Mutual Fund, essentially advising short- to medium-term investors to stay away from longer duration debt funds at the moment.

If you have a medium-term investment horizon ranging from 12 to 18 months, you could focus your investments partially into shorter-maturity corporate bond funds — debt funds that buy relatively short-term corporate bonds of slightly lower than top-notch credit quality. These funds benefit from an improvement in the corporate earnings cycle. Additionally, you may consider investing into relatively short-term, accrual-based income funds, if you have a time horizon of a year or so.
“Despite the jolts of demonetisation and GST, the earnings cycle appears to be looking up. On the back of this, we have started seeing upgrades catch up with, and in some periods, exceed downgrades. These signs point to a more positive outlook for credit,” says Sivakumar, while simultaneously stressing upon the need to diversify and largely remain invested in high-quality companies in the current environment.

Pandya is more circumspect when it comes to advising clients to take on credit risk. Describing the credit environment of India as “a challenging one” throughout 2017, he says, “In such an environment, it is difficult to gauge the creditworthiness of a borrower”. Pandya advises clients to stick with funds that focus on the shorter end of the duration curve.

Those with longer investment horizons of three years or more can consider investing into dynamic bond funds or longer-duration debt funds, but in a staggered manner through 12-18-month systematic investment plans instead of committing lump sums. However, investors should note that this is a slightly higher risk strategy that could yield erratic returns in the short to medium term.

“Any sustained rise in yields can be used as an opportunity to systematically invest in bonds with rising yields, resulting in rupee cost averaging over the long term,” advises Jajoo.

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