Investors in fixed income-oriented mutual funds have the option of investing in various categories of funds ranging from plain liquid to long bond funds. These funds vary in their risk-reward profile. Liquid funds are the most stable in returns with portfolio maturity less than three months. Long bond funds are more volatile with portfolio maturity typically in the range of 10 to 15 years, may be higher or lower depending on the fund manager's views. If interest rate movement works in your favour, your investment in long bond funds will give better returns than liquid funds, and vice versa.
Currently, the view on interest-rate movement is positive. We expect the Reserve Bank of India to ease policy rates further by 0.25% to 0.5%. Inflation is within control, consumer price inflation (CPI) inflation was 3.63% in November. Though the RBI expects it to be approx 5% by March 2017 and approx 4.5% a year hence, it is acceptable in a growing economy like India.
The government is committed to bringing fiscal deficit down to 3.5% of GDP in 2016-17 and 3% the year after, and is expecting better direct-tax collection due to demonetization. However, the market has run ahead; the 10-year government security yield, was approx 7.85% in February 2016 and has eased to approx 6.4% now. That is to say, interest rates in the bond market have already eased, following RBI rate cuts of 1.75% since 2015.
To give a perspective on the working of funds, there is a fund called yield to maturity (YTM) fund, which is the yield on the portfolio and there is a recurring expense rate that is charged to the fund. The net accrual rate i.e. the rate at which the fund earns for its investors, prior to market movements, is the net of expenses YTM. For illustration, let us say there is a short-term bond fund with a YTM of 7.25% and expense ratio of 1% i.e. net running yield of 6.25%. As against that, there is a long bond fund with a portfolio yield of 7% (yield is lower because of government securities in the portfolio) and expense ratio of 1.5%, hence a net yield of 5.5%.
For the long bond fund which has lower running yield, it will take a significant rally in interest rates in the market to beat the short-bond fund with a higher yield, which may or may not happen. Moreover, long bond funds are more volatile in performance. With the 10-year benchmark security trading around 6.4%, there is some scope for easing of rates, but not to a significant extent. That is to say, long bond funds do not look attractive from a risk-reward perspective at this juncture.
GUARD AGAINST UNCERTAINTY
- Long bond funds are more volatile in performance. With the 10-year benchmark security trading around 6.4%, there is some scope for easing of rates, but not to a significant extent
- Liquid funds are the most stable in returns with portfolio maturity less than three months, unlike long bond funds that come with risk-reward returns
The writer is an independent financial analyst
