In short-term, long bond funds outperform only when the rates come down meaningfully.
Things have improved for fixed income funds. The portfolio’s yield-to-maturity (YTM) mentioned in factsheets, has improved from the lows, two years ago. Now, debt fund YTMs even net of fund expenses are comparable with bank fixed deposits. So, the question is – whether it is the right time to move to long maturity bond funds. Before we answer that, let’s go through the basics.
The appeal of debt funds vis-à-vis other assets is that you can map your investment horizon with an appropriate fund. For a very short horizon like a week or a month, there are liquid funds, and for three-four months, there are ultra short term funds. For a horizon of nine months to one year there are money market funds, and for two to three years, there are corporate bond funds / Banking PSU Funds. Ideally, you should do your cash flow calculations and invest in the appropriate fund. As a ballpark, you may match your horizon with the portfolio maturity of the fund.
Then, there are long maturity debt funds e.g. gilt funds, and dynamic bond funds where the fund manager modulates the portfolio maturity.
These are long maturity bond funds as the portfolio maturity is longer than the other debt fund categories. The implication is, the movement of bond prices of relatively longer maturity, as per interest rate movements, is proportionately higher. Since interest rates and bond prices move inversely, when interest rates come down, long bonds gain more than shorter ones and vice versa. One way of looking at putting your money in long bond funds is to have a very long investment horizon, so that market cycles even out and the coupon accruals in the portfolio provide a cushion.
The other approach is to enter long bond funds when interest rates are likely to come down. If the call turns out correct, long bond funds will gain more than the shorter maturity bonds. This is the context we are discussing here.
The arguments being given by some people in the market in favour of investing in long bond funds at this juncture, are: (a) RBI is in the last leg of the rate hike cycle (b) forthcoming rate hikes are mostly reflected in the price level in the bond market and (c) inflation is expected to ease over the next few months. All these arguments are correct. Then why not take a call on long bond funds?
Let us look at an analogy. You are caught in city traffic, and are driving at a very slow pace. The jam clears. Then you gather speed, say 40 kmph, but you don’t hit 100 kmph as you are still in the city. You would hit 100 kmph on the highway. Coming to our scenario, the RBI is expected to hike rates in the 7 December review meeting. This is already discounted i.e. it is reflected in the price. In the next meeting on 8 February 2023, there may or may not be a rate hike, depending on the situation. That is expected to be the last rate hike in this cycle. Though the RBI has called an unscheduled MPC meeting on 3 November 2022, it seems more of procedural nature to discuss the explanation to Parliament on inflation breaching 6% limit.
In our analogy, the traffic jam is about to clear. Thereafter, the RBI is expected to pause on interest rates,. It would be more or less a steady state of affairs. The time period of RBI’s pause is anybody’s call, let us say one year. Thereafter, as and when inflation eases, the RBI may look at cutting rates. At that juncture, entry into long bond funds with an opportunistic approach would be fruitful. However, it is then, and the timing of that cannot be projected now.
Over a short holding period, long bond funds can outperform only when interest rates come down meaningfully.
To draw on the analogy again, there is a reason why cars have second and third gears. Put on the fifth gear only when you hit the highway.