Rising Bond Yields & Debt Fund Investors

Bond yields closely track the movement in monetary policy rates, inflation, central and state government borrowing programs and interbank liquidity, amongst others, and we are already witnessing an accommodative monetary policy and large fiscal deficit, which is fuelling inflation expectation and rise in bond yields

The equity market, in the last couple of months, has become quite volatile. It is trading in a wide range.For example frontline equity index Nifty has gone down by 1,000 points and recovered more than twice in a span of less than three months. One of the chief reasons for such volatility is the spike in bond yields globally. The yield on the benchmark US Treasury note rose to more than 1.7 per cent recently, highest in the last 14 months. Even the Indian benchmark bond yield has moved up from below 5.9 per cent at the start of the year to little more than 6.2 per cent over the next two and half months.

Bond yields closely track the movement in monetary policy rates (interest rates at which the RBI borrows from and lends money to banks), inflation, central and state government borrowing programs and interbank liquidity, amongst others. We are already witnessing an accommodative monetary policy and large fiscal deficit, which is fuelling inflation expectation and rise in bond yields. The equity market has an indirect bearing on the rise in the bond market; however, the debt market is directly impacted by any rise in the bond market. This is clearly reflected in the performance of debt funds. The graph below shows the performance of the debt category funds in the last three months.

We see that out of 16 categories, eight categories have witnessed a fall in t heir net asset value (NAV) in the last three months. One of the reasons for negative returns by these funds is the inverse relation between bond yields and bond prices. They move in opposite directions and this relation is stronger with longer duration debt instruments. This is the reason funds holding long duration papers are the worst performers with the rise in bond yields. Nonetheless, funds holding short duration debt instruments having maturity between one and four years have performed relatively well.

The graph above depicts the inverse relation between average modified duration and returns in a rising interest rate scenario. In case of falling interest this will become direct i.e. funds with longer modified duration will generate better returns than funds with lower modified duration.

Duration versus Accrual
The reason for such a difference in performance is attributed to the way debt funds derive their returns. There are two source of return for a debt fund; first is the capital appreciation of the debt instruments they hold in their portfolio and second, the interest they receive on them. Funds that earn majority of their return from interest are considered to be following an accrual strategy. Such funds are ideally centred to receive interest income in terms of coupons offered by bonds.

They typically invest in short to medium maturity papers which are of mid-to-high quality while concentrating on holding securities until maturity. The returns of such funds are less impacted by the movement in the interest rate, which has a greater bearing on the price of the bond. Nevertheless, in case of funds following a duration strategy, they tend to get most of their returns from the appreciation in the price of bonds they hold. These funds are open to interest rate risk and can bear capital losses if the interest rates go higher. Long duration funds and gilt funds serve the duration-based strategy and hence they are witnessing a negative return from this category now.

An Investor’s Approach
The best way to build your debt portfolio is to invest in funds that have a same duration (Macaulay duration) as your financial goal. For example, if you want to send your child for higher education in the next three years, you can park in funds that have Macaulay duration of three years. In such a scenario you will not get much impacted due to change in interest rate. Nevertheless, if you have invested for a goal that is more than six to seven years, a change in interest rate may not impact you much. In the graph below we see the annualised returns offered by different categories of debt funds.

It is clear that funds holding debt instruments with higher duration tend to perform better in the longer run. Gilt with 10-year constant duration is a debt fund that has the highest duration and has generated return in excess of 9 per cent every year in the last 11 years.

The lowest return is generated by overnight fund that in the same period has given return of around 6.5 per cent. The significance of the date chosen for comparison of these returns is to highlight a complete interest rate cycle. The graph below shows how the key policy rate (repo rate) has changed over the years. From its low of 4.75 per cent in the month of April 2009 it has gone up to 8.5 per cent in October 2011 and again to 4 per cent in May 2020.

Therefore, if your investment horizon is longer, there is no need to worry about this transient volatility. Duration strategy will suit you; however, you need to digest sessions of volatility. Nevertheless, if your investment horizon is shorter, you can shift from long duration bond funds to funds that have shorter duration. An accrual strategy will suit you. Accrual suits moderate and stable investors as they do not have much volatility and are durable. But if you are a moderate investor, remember not to go for credit opportunity funds or funds with large credit risk as they may generate loss.

These funds are only fit for high-risk investors. Moreover, if you want to make a tactical allocation then again it is the right time to shift towards shorter duration bond funds. Dynamic bond funds are the most suitable for those investors who do not want to track the interest rate and its impact on the NAV of their funds. These funds develop their portfolio and strategy as per the rate scenario.