Debt funds: An improbable encore

Vikram Srivastava

For the last two years, debt funds have shown a stellar performance. Most of the funds have given returns in the range of 15 to 20 per cent.

Medium- and long-term gilt funds have done particularly well with some giving returns in excess of 25 per cent. This has conditioned the investors into believing that debt funds can generate the same kind of returns repeatedly over time.

However, the big question is whether the funds would be able to replicate their success. In all likelihood, this performance may not be sustained.

Generally, debt funds total returns constitute three components: the running yield on the portfolio, capital appreciation and trading gains.

For the past two years, returns from capital appreciation has been the single most important factor that has boosted the returns of the funds. The yield on ten-year government security has declined from 8 per cent in January to 6.24 per cent last week.

In fact, some broad-brush calculation shows that nearly a quarter of the returns generated by debt funds last year was on account of capital appreciation.

Since most funds have an average maturity of five years, we took capital gains on a five year paper to be an indicative figure.

Besides, there was huge volatility in the debt markets earlier this year with big swings in bond prices on fears of a war between India and Pakistan on the domestic front and Iraq and United States on the external front.

This pushed the mutual funds to trade aggressively to profit from price fluctuations. Thus another chunk of the returns was on account trading gains. These factors helped the debt funds posted hefty returns despite the ordinary yield on their portfolio.

Essentially, only half of the returns is due to interest income that is generated by a fund.

In other words, if interest rates were to remain stable and fund managers do not earn anything out of trading, then they would generate about half the returns they generated this year.

In all likelihood, debt funds will manage to perform only marginally better than that. The market expectation is that interest rates will stabilise. Rajiv Anand, fund manager, Standard Chartered Mutual Fund, says, "The interest rates are not expected to fall below 6 per cent level in the near future."

Sandesh Kirkire, fund manager, Kotak Mahindra Mutual Fund, agrees. "Barring major change occurs in government policies, the yields are not likely to fall below 6 per cent."

This implies that the gains by the way of capital appreciation will be minimal this year. Based on current yields, funds can generate only about 7 per cent through interest income.

Trading income will be limited as active trading has a cost associated with it that reduces the benefit from trading.

Fund managers may not want to trade too much if they don't see sure-shot moves. Besides, trading in some sense is also dangerous because the fund manager can even lose if he is caught on the wrong foot.

All this implies that the returns from debt funds are due for a decline. Staying invested in longer dated papers may not generate returns either.

Last year, funds such as the Alliance GSF Long Term and Tata GSF realised returns of 17.5 and 19.1 per cent, respectively, by investing in the longer end of the maturity spectrum.

However, this year, the strategy may not work as the yield curve is flattening. The spread between the 10-year and the 30-year gilt has reduced to less than 70 basis points. So, there won't be much scope for differential returns by taking aggressive bets on the duration.

Also, at the start of current year there existed an arbitrage opportunity between the corporate paper and the government securities.

There was a yield differential -- or spread -- of 280 basis points between a five-year corporate paper and government securities of the same maturity. This meant that there was a chance of increasing returns through moving into corporate paper. However, even this opportunity has been reduced over the year.

The spread has come down to under 60 basis points. Therefore, it would not pay the funds to move out of government papers into corporate papers to improve their returns.

Given the limited opportunity for capital appreciation, the funds will have to rely on interest income and gains from trading in the future.

As interest income has fallen and the gains from trading expected to be negligible, the funds are not expected to show large returns this year.

As mentioned before the fund managers expect the interest rates to come down to 6 per cent. On this basis the fund managers expect the funds to earn between 7 to 9 percent returns.

Says Dhawal Dalal, fund manager, DSP Merrill Lynch Mutual Fund, "The returns from debt schemes should returns be in the region of 7 to 9 per cent if the yields fall further to 6 percent."

The sentiment is validated by Milind Nandukar, fund manager, Sun F&C Mutual Fund. "The debt funds are expected to give returns in the region of 7 to 8 per cent this year," he says.

However, like any investment vehicle, debt mutual funds come with their associated risks. The risk here takes the form of an event risk of a war between Iraq and the United States.

The loss suffered would depend upon the length of the war. Says Rajiv Anand, "In case the war lasts a month or more, we could see the interest rates spike upwards by 150 basis points or more. This would cause a loss of 6 per cent or more for funds." "The loss of 6 per cent would be made up in a year," adds Milind Nandukar.

However, the managers were quick to point out that such huge losses would accrue only if they did not act when the interest rates were moving up.

They said that duration of the funds would be shortened immediately. Besides, interest rates would stabilise as soon as the war gets over, reducing the losses.

2002: The Year That Was

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