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Long duration debt funds
The Reserve Bank of India ( RBI)' s September 30 monetary policy review left many disappointed, as the wait for loan rates to fall became longer. However, one can take advantage of the falling bond yields to invest in debt mutual funds.
Bond yields have started easing due to a fall in inflation, a drop in oil prices and expectations that an increase in US treasury yields might take longer. Experts say as bond prices are starting to rise, this is the time to invest in income funds, just before they rally.
According to Bloomberg data, the yield on the 10- year benchmark government security, which stood at 8.55 per cent on September 1, fell to 8.36 per cent on October 22. By comparison, the yield on the 10- year US treasury is 2.2 per cent.
Easing inflation numbers and global oil prices are two factors that work in favour of bond prices. It is possible RBI might cut interest rates earlier than expected, which will help bond prices gain further. RBI is expected to cut interest rates only in the second quarter of 2015. But if oil prices remain where they are and inflation remains under check, it is possible the central bank might cut rates earlier. Therefore, income funds will do better when rates decline," he adds.
Allocations towards long- duration funds, as fundamentals point to attractive returns in the next two to three years. We believe both government and corporate bonds are likely to do well on account of improving fundamentals. High- duration funds are at the higher end of the volatility curve in the short term, but have a potential to deliver significant returns over the long- term investment horizon.
So far this year, foreign institutional investors have invested $ 22 billion in Indian bonds. As other markets such as Europe, the US and Japan are facing headwinds, demand for Indian bonds will continue to be strong. And, when the US starts raising interest rates, the yield curve for the two to three- year bonds will start rising, says Dalal.
Retail investors are better off investing in income funds rather than gilt funds, as the latter are more volatile. It is better to invest in income funds with average maturity of less than five years, which have a combination of bonds and government securities ( GSecs) and can tweak their average maturity based on interest rate movements. With income funds, the accrual part will ensure investors continue to generate returns, even in the absence of rate cuts. Also, it will provide an opportunity to gain from a fall in yields in corporate bonds, with a recovery in corporate earnings. Dalal agrees income funds give better risk- adjusted returns compared to G- Sec yield funds. As the average maturity of G- Sec funds are higher, they tend to be more volatile.
A two- to- three- year perspective, investors can make some allocation to longer- term funds, both income and G- Sec yield funds. As all macroeconomic factors in India are taken care of, the possibility of inflation rising is low. The only risk is a rise in the interest rate in the US. On the domestic front, if inflation comes under control, the scenario will be one of secular downward movement in interest rates. Similarly, when interest rates are cut, G- Sec yields will also come down
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