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| Capitalstars Investment Advisor |
Due to the Reserve Bank of India's (RBI) - Operation Twist, the long duration mutual fund schemes have gained a lot. However, financial experts are giving a word of caution to the debt mutual fund investors. Here's why.
The RBI has carried out an unusual maneuver. Operation Twist involved buying 10-year government bonds while selling those maturing in one year. What does this mean for bond fund investors? What should be the approach of those playing on duration after this?
Here is what happened. In the weeks leading up to the central bank’s actions, the bond market scales had tipped sharply to one side. The yield on longer tenure government bonds had spiked in comparison to that on short-term government bonds. Longer-dated bonds typically enjoy a ‘term premium’ or higher yield as investors perceive these to be riskier given the uncertainty associated with a longer horizon. Investors demand a higher yield for holding longer-dated bonds. So the yield curve, which charts the prevailing yield on bonds starting from shortest maturity bonds to the longest, tends to slope northward.
However, due to prevailing economic conditions and high uncertainty in bond markets, the yield curve had become steeper than usual. The spread in yields had widened considerably. The RBI decided to step in and smoothen the yield curve through simultaneous buying of long-dated bonds and selling of short-dated bonds.
This achieved the objective of bringing down elevated yields on long-dated bonds, without tinkering with interest rates. The bond market duly responded, with the yield on the 10-year benchmark bond falling from 6.8% on 16 December to 6.52% towards the end of the year. Bond yields are a function of bond prices, with the two moving in opposing directions. The spread between long and short tenure bonds narrowed significantly, checking the imbalance in the yield curve.
With RBI taking a different approach, longer duration bond funds stand to gain a lot. However, experts caution against reading too much into the apex bank’s move. Investors should not expect more such moves in the future, say fund managers.
For the bond markets, this action is more confounding rather than providing any clarity, says Dhawal Dalal, Head-Fixed Income, Edelweiss Mutual Fund. “This is actually a conundrum for the bond market as the central bank’s stated intention has never been to manage the yield curve. It has been geared more towards inflation targeting,” he says. Avnish Jain, Head-Fixed Income, Canara Robeco Mutual Fund, argues, “The central bank’s action appears an ad-hoc measure rather than a prolonged policy shift."
Longer duration funds benefited from rate cuts last year
Besides, the underlying sentiment in the bond market suggests that room for further upside in long-dated bonds is limited. There are a few visibly strained macro indicators putting shackles on the bond markets. Inflation, which had been benign until a few months back, has been inching upwards owing to a sharp uptick in food prices.
“Inflation is likely to continue its upward march in the first half of the new year,” says Jain. Higher inflation may force the central bank to be cautious and extend the pause in interest rates, rather than easing rates to stimulate the economy. This will put a cap on a further rally in bond prices.
Moreover, the fiscal math seems stretched. With the continued shortfall in GST collections and likely big miss in this year’s disinvestment target, the government is staring at a slippage in its fiscal deficit. A wider fiscal deficit—gap in government’s expenditure in relation to its income— implies it is likely to be forced to borrow more. This is bad news for bond markets as an additional supply of bonds will bring down bond prices.
Given the sober sentiments, experts caution against being adventurous with duration play. Induration strategy, investors hunt for capital appreciation in longer-dated bond funds on the back of falling interest rates. Investors in long-duration debt funds and gilt funds have reaped a windfall over the past year, amid a sharp cut in interest rates. These funds have gained 12.4% and 10.7%, respectively, on average.
Going forward, the gains from this basket are likely to be muted. Dalal suggests this is the right time to book gains in long-duration funds. “There is likely to be a gradual upward shift in bond yields as the bond market is building in a scenario of extra government borrowing and higher inflation,” he says. Fund managers recommend sticking to shorter-term bond funds for the near term. Shorter the duration, the less susceptible it is to interest rate movements. “It would be best to stay at the shorter end of the yield curve,” suggests Jain. Maintain the bulk of your debt fund portfolio in short duration or low duration debt funds.
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