Strategies to ride out interest rate cycles

Few debt funds help deliver consistent returns that are better than what FDs offer

Over the past few months, the domestic bond market has been impacted by tightening global liquidity and concerns over rising inflation and fiscal slippages on the domestic front.

After cutting the repo rate by 25 bps to 6 per cent in August 2017, the RBI has been in a long pause mode, citing possible upside risk on inflation.

The yields on the 10-year government securities rose by around 110 basis points to 7.56 per cent over the last six months. This has, in turn, hurt the performance of long-term debt funds.

The long-term funds such as gilt long-term, dynamic income and, long-term income funds have delivered poor performance with an absolute return of -2.1, -0.5 and 0.1 per cent respectively in the last six months. While long-term gilt funds deliver stellar returns in falling rate cycles, for investors who do not have the appetite to weather sudden volatility in returns or erosion in NAVs, which funds could be deemed as ‘safe’ options?

Read on the find out the type of funds you must invest in to weather all types of interest rate cycles.

 

 

Rising rate scenarios

A comparative study of the performance of the various debt funds categories during the current and the previous rising interest rate scenarios throws some interesting insights. We chose four rising rates scenarios in the domestic bond market for this study; the periods between February 2008 and July 2008; January 2009 and November 2011; May 2013 and April 2014, and July 2017 and March 2018.

Factors that led to the rise in rates in each of these phases were different. The movement of interest rates is determined by demand and supply, RBI policy, growth in the economy, inflation, global liquidity and uncertainty.

Some key takeaways

One, funds that followed the accrual strategy (generating returns through interest on the bonds) — liquid and ultra-short term categories — managed to register positive returns in all the rising and falling rate cycles.

They are least sensitive to the interest rate movements as their performance is based on the liquidity condition in the banking system. Aditya Birla SL FRF-ST, Franklin India Ultra Short Bond and Sundaram Ultra Short-Term are some of the best in the category.

Two, funds that combine accrual and low-duration strategies managed well in rising rates scenarios. They also delivered better returns when the short-term rates were relatively higher. Categories such as banking and PSU debt, credit opportunities, and short-term income follow this strategy. Schemes such as Sundaram Banking & PSU Debt, Aditya Birla SL ST Opportunities and HDFC Floating Rate-LT from this category did exceptionally well.

Credit opportunities funds capitalise on the credit risk while adopting the accrual strategy. Franklin India ST Income and DSPBR Credit Risk Fund are some quality funds from the category.

Three, medium to long term income funds, which reduced and maintained their average maturity in the three to five year band not only managed to contain the drop in their NAVs in rising cycles, but also quickly changed track when there was a shift in rates.

Normally, during rising rates, fund managers prune their holdings in long-term G-Secs and corporate debt while increasing investment in short-term debt instruments.

Four, funds that adopted a blend of all the above-mentioned strategies were the best across cycles. Aditya Birla SL Treasury Optimizer, ICICI Pru Banking & PSU Debt and Franklin India IBA are some of the schemes that delivered consistently.

Five, though the dynamic income funds managed their duration calls actively, most of the schemes were unable to contain the losses well in rising interest rate scenarios. Some of better performing fund from the category are Aditya Birla SL Dynamic Bond and Kotak Flexi Debt.

Six, most of the Gilt-long term and long-term income funds generated negative returns during the rising interest rates periods. It is better to avoid such funds in the rising scenarios.

For individual investors, it may be a tedious task to get into the finer aspects of debt fund strategies to decide what works. Investors with a moderate risk appetite, who stick to quality debt funds with a three to five year time horizon would derive returns that are better than what FDs offer. From our analysis, the schemes that have been consistent across cycles are Aditya Birla SL Treasury Optimizer, ICICI Pru Banking & PSU Debt, Franklin India IBA, Kotak Flexi Debt Fund and UTI ST Income Fund.

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