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FundsIndia Debt Strategies: Should you play the duration game now?

October 5, 2016 . Vidya Bala

We’ve also talked about the rate cut on this week’s episode of Talk FundsIndia. Play our podcast below to listen in as Srikanth Meenakshi, our COO, and Vidya, talk about the rate cut and its impact.

The market got what it wanted – a rate cut. The RBI’s Monetary Policy Committee made its debut in the fourth bi-monthly Monetary Policy Statement 2016-17 with a 25 basis repo rate cut to 6.25%. This consequently saw a similar cut in reverse repo rate, the marginal standing facility (MSF) rate and bank rate.

The bond market appeared to have already factored such a rate cut with yields of the 10-yer gilt having already moved over 20 basis points in the last few days to 6.77% pre-policy and remaining flat post announcement.

So should you celebrate the rate cut and participate in full form now in the duration play? Before we give our views on this, let’s take a look back on how long the debt rally has prevailed to know if it holds steam.

A long rally

As rate cuts have not been swift, it is likely that you may have missed out the interest rate rally that has been in play for 3 years now. From 10-year gilt levels of 9.5% to sub-7 percent now, the rally has been steady, delivering double digit returns for debt funds that played the duration game.

In fact, those of you who plunged into the market when we made a rather early call with dynamic bonds in October 2012 (which was followed by rate hikes in 2013) would still have made a cool 11% annualised return over these 4 years.

With the kind of rally that has played out, the scenario in debt now is not too different from an investor entering equity markets when their valuations are steep. However, fortunately, unlike the equity markets, the debt markets respond to economic indicators well enough and inflation, a key indicator, has provided room for rate cuts thus far and may well provide for one more (thanks to food inflation, a key influence in CPI showing signs of sustained fall), other things remaining the same.

And the good news is that, even if the debt rally may not be as high as it was in the past 3 years, you will still comfortably beat your fixed deposit rates over the next 2-3 years by a good margin.

Not entirely a duration play

We think this could be the last leg of the duration game, with perhaps another rate cut, if things move in the current direction. That means, there are still gains to be made, but not by taking very long duration calls – like the way one would, by entering long-term gilt funds. Why is this so? As we come towards the close of a debt rally, the highest duration calls respond less to rate cuts and the medium-term ones respond better.

This is because shorter duration calls respond more to rate cuts while the longer end respond more to macro developments towards the fag end of rate cuts. The market also becomes conscious of the risk premium to be paid for longer tenure beyond a certain point and may not further reduce the spread between the short rates and long rates. This is visible in the latest 10-year G-sec rates actually trading above the older G-sec rates. The short end on the other hand, can continue to react more to liquidity and rate changes.

Hence, unless we are to see a noticeable dip in inflation, the long end of the curve may react with less enthusiasm.

That means you need to choose funds that will not have a very high duration at this point or are reducing their tenure.

Besides, what do you do post the rally? The fund should also be prepared to slowly make the transition by stocking up on accrual. Dynamic bond funds are typically the ones that can be expected to this. One,they will reduce the average maturity of their instruments and two, slowly add some accrual instruments.  This might seem contrarian at a time when a rate cut happens but such moves are seldom done after a rally is over. It needs to be done while it is in its last leg; only then the returns earned can be preserved than lost (as is the case with gilt funds).

We think you should go with funds that have, in the past, proven the above strategy successfully and at present seem to be readying for it.

Where to invest

For those of you willing to stay invested for the medium to long term (at least 2 years and preferably 3 years or more to get capital gains indexation benefit), you can consider Birla Sun Life Dynamic Bond Fund and UTI Dynamic Bond Fund (spread between the two). Aside from a good track record of consistent performance, we chose the two for two different reasons: Birla Sun Life Dynamic Bond went overweight on long-term gilts in January 2016, holding 84% in very long-term gilts. It has now brought this down to 67%, while adding AAA and quality AA-rated bonds for accrual. UTI Dynamic Bond on the other hand has already reduced its duration, between June and August, thus readying itself for the final leg of rally.

For those of you wanting to participate in this rally but with a shorter time frame of 1-2 years, then a similar strategy, albeit with lower duration can be had with Birla Sun Life Treasury Optimizer

Fund1-year return3-year returns
Birla Sun Life Dynamic Bond12.8%12.6%
UTI Dynamic Bond10.9%11.5%
Birla Sun Life Treasury Optimizer11.7%11.3%
Returns over 1 year annualised. Returns as of October 4, 2016

FundsIndia’s Research team has, to the best of its ability, taken into account various factors – both quantitative measures and qualitative assessments, in an unbiased manner, while choosing the fund(s) mentioned above. However, they carry unknown risks and uncertainties linked to broad markets, as well as analysts’ expectations about future events. They should not, therefore, be the sole basis of investment decisions. To know how to read our weekly fund reviews, please click here.

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