Making sense of the decreasing debt fund returns

In the last few weeks, you would have suddenly noticed that some of your debt mutual funds have given slight negative returns. The extent of negative returns would be different based on the category of funds you are invested in. Nevertheless, there is a good chance that you are beginning to worry as to what is happening. Now, before you jump the gun and take some hasty decisions, let me try and help you make sense of what is happening. Once you understand the reasons, you can make an informed decision.Two Key Drivers of Debt Fund ReturnsDebt fund returns should be anchored to Net YTMs and not past returns. If interest rates go up, the returns will be lower and vice versa. The extent of impact due to interest rate changes depends on the modified duration of the fund – the higher the modified duration higher the impact on NAVs. If interest rates go down, we will end up with higher returns and everyone is happy.But if interest rates go up, returns come down sharply in the near term especially for funds with higher modified duration. This is the context that we must be aware of. Interest rates as seen from history move through cycles i.e they have periods where they go up followed by a period where they come down and this keeps repeating. While the duration and magnitude of these cycles are difficult to predict, we need to have an approximate view of where we are in the interest rate cycle to make sure that our debt fund portfolios are appropriately positioned.When interest rates are expected to come down, it makes sense to go for funds with slightly higher modified durationWhen interest rates are expected to go up, it makes sense to go for funds with a low modified duration.So here comes the million-dollar question: Right now, where are we in the interest rate cycle?In our view, the ‘declining yields’ phase is behind us and we must prepare for a rising yield environment going forward. What this means for us is that funds with higher modified duration (which also had great returns in the past when yields were falling) may exhibit higher volatility (read as negative returns) in the short run. The returns from these funds may be back-ended and will require longer investment time frames.We are in a ‘rising yield’ environment and we expect yields to gradually inch up over the next year albeit in a gradual & not-so-sudden manner. The rate cut cycle is behind us (read as the period of excess returns from debt funds) and you will have to prepare for relatively higher volatility in your debt fund portfolios over the next 1 year. The extent of volatility will be dependent on the modified duration profile of your funds. Higher the modified duration, the higher the volatility to be expected. Debt mutual fund portfolios must be positioned for the rising yields environmentWhy do we think you must prepare for a ‘rising yield’ environment over the coming quarters?Higher-Than-Expected Government BorrowingAnnounced in the recent budget – led by higher Fiscal Deficit – 9.5% of GDP in FY21 and 6.8% of GDP in FY22Gross Market Borrowing for FY22 at Rs 12 lakh crs – To put this in perspective, FY21 gross market borrowing estimate of the centre government before the pandemic was ~Rs 7.8 lakh crsRs 80,000 cr additional borrowing for FY 21Given the extended fiscal glide path government’s market borrowing is likely to remain elevated for longer periodHigher expected borrowing from State GovernmentsPause in Rate CutsGradual Normalization of Liquidity measures undertaken by RBI during the Covid CrisisPossible Inflation Pressures due to Economic Recovery and Commodity Price increase (especially crude)Bond Yields near decadal lowsGlobal Yields inching up in recent timesWhy do we expect the rise in yields to be gradual and non-disruptive?In the monetary policy statement on Feb 05, the RBI reiterated its commitment to support the bond market and promised an ‘orderly completion of the government’s market borrowing program in a non-disruptive manner’A sudden sharp increase in interest rates willincrease the cost for the government’s large upcoming borrowing programimpact the economic recoveryRBI will want to avoid this scenario and will attempt to keep the yields in a narrow range We expect RBI to continue using OMOs and other tools (at least in this calendar year) to ensure that yields do not suddenly move up sharplyOur view is that yields are expected to gradually inch up but in a gradual and non-disruptive mannerHow do you position your debt portfolios for a rising yield environment?Going forward, we prefer funds with lower modified duration (1 year or less) as these funds are well suited for a rising yield environment. They exhibit much lower volatility when yields increase and quickly reset to the higher yields thus improving future return potential. With the broad objective of striking a reasonable balance between near-term volatility and long-term portfolio returns, here is our debt fund portfolio construction approach.81771316(The author is the head of research, Funds India.)

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