When To Exit Debt Funds?

If you invested three years ago, you should shift to short-term bond funds.

Many investors focus on timing their investments. If the investment is not goal based, then the timing of the exit is important. Unfortunately, the discussion on when to exit usually comes up when the going in the market is not good.

In the context of long-term bond fund or bond investments, the latest turnaround in the market vis-à-vis expectations of investors and advisors happened in February when the RBI Monetary Policy Committee changed its stance of monetary policy from accommodative to neutral. Yield moved up by 40 bps in reaction, as the banking regulator signalled no rate cuts in the near future.

If this means a turnaround in the interest rate cycle, there is a case for considering exit from long bond fund investments. The rationale is, in short bond funds the recurring expenses charged are relatively lower and the net carry (net accrual level of the fund) is better than long bond funds, i.e., income funds and dynamic funds.

If interest rates do not come down, the longer duration of long bond funds will not outperform short-term bond funds. Also, long bond funds may be more volatile. Now the critical question is timing the exit. The decision is easy for investors who invested in debt funds three years ago as such investments must have reaped benefits of rate cuts coupled with long-term capital gains tax benefits. These investors should consider debt funds having shorter average duration.

However, the exit decision is a little tricky for investors who invested in long-term debt funds with an objective to gain from rate cuts. Returns so far are not as expected and no additional tax benefits in the growth option. In the current market scenario, there is no other lucrative avenue that would justify exit with muted returns. To be sure, there is no urgency as interest rates are expected to be stable for quite some time. Inflation is under control, monsoon forecast by the Met Department is 96% of long period average, the demand-supply equation for primary bond issues is favourable and the RBI policy stance is neutral, not that of tightening. US Fed may hike rates, but India’s markets are largely driven by domestic demand.

For investments in growth option that are nearing three years, it is advisable to wait for some more time. For new investments, there is no cheer in store as nothing could lead to a rally that would make up for the muted returns. For these investments, investors and advisors have to start weighing other options in terms of opportunity cost, i.e., expected returns from the current investment and other avenues available.

For any exit decision, the big question is: where to invest the proceeds. There is a tendency, when the exit is with muted returns, investors invest in high risk instruments to make up for the opportunity lost. This should not be the case, as these are market driven investments and may lead to losses. Advisors should encourage such clients not to take irrational decision and make investments according to their risk return profile.

Here are a few investment options available for investors with similar risk-return profile:

  • Short term bond funds – good portfolio quality
  • Credit call short term bond funds – better carry i.e. interest accrual
  • Arbitrage funds – no equity market call, tax efficiency
  • MIP funds – limited equity exposure of approximately 20%
  • Bonds from primary or secondary market – matching the risk profile and horizon
  • Preference shares – tax efficiency even if there is 10% tax incidence

To summarise, interest rates are expected to remain stable in the near to medium term. You may advise your client to stay put in long bond fund investments, if it is a goal based investment. Else, since interest rates are here to stay, there is a case for shifting to other avenues.

Source: https://cafemutual.com/news/guestcolumn/300-when-to-exit-debt-funds

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