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June 7, 2011

ABC of Fixed Income Investing: Factors That Make Fixed Income Funds Attractive
In this article, we discuss the factors that affect the performance of fixed income funds.

by Dhanashri Rane

ABC of Fixed Income Investing : Factors That Make Fixed Income Funds Attractive

Retail investors in India can be said to be reasonably well informed when it comes to investments in equities, real estate or even assets like gold or silver. The Fixed Income asset class, however, is not so well known. As a tool for diversification, and as a safe avenue for volatile times, understanding this class is important. Even experts agree that greater retail participation in the fixed income market in India will make it more robust.

Fundsupermart.com has always tried to draw notice to this asset class through various research and personal finance articles on the website. Taking this initiative further, we bring to you this series explaining basics of fixed income investments!

A. INTRODUCTION TO THE FIXED INCOME ASSET CLASS>>

B. Understanding YIELD>>

C. SECURITIES THAT DEBT FUND MANAGERS INVEST IN>>

D. INTRODUCTION TO DEBT MUTUAL FUNDS>>

E. Types of Risks>>

F. 4 Important Things That YTM Tells You>>

G. Factors That Make Fixed Income Funds Attractive

Interest Rate

Interest rate is the first and the most significant factor determining the performance of fixed income assets.  However, there is no standard index, unlike the BSE Sensex for Equity, which would tell us how the fixed income funds may be faring. Retail investors normally look at bank deposit rates whereas, economists watch the monetary policy rates and the ten year government security, referred as the benchmark 10 year G-sec.

The Reserve Bank of India conducts a review meeting every quarter to decide on the policy rates. Based on macro-economic situations, these rates are used as lever by the central bank to manage the economic environment in the country.

  • Repo: Banks borrow from RBI at the Repurchase (Repo) rate. It is at 7.25% currently.

  • Reverse Repo: Banks park their idle cash with RBI at Reverse Repo Rate and presently, it is at 6.25%.

  • Bank Rate: This base rate is set by the central bank and stands at 6% currently. Any revision in this rate is an indication for the banking industry to follow a similar action. So, an increase in the bank rate is a signal for banks to raise their lending and deposit rates and vice versa.

The movement in the yield from the benchmark 10 year G-sec reflects the sentiment in the debt market. The negative sentiment is emphasized by rise in yield; in contrast, the fall in yields causes a cheer in the market as the bond prices go up.

  • Benchmark 10 Year G-sec: The 10 year coupon bearing government security. At present, the 7.80% 2021 bond is the benchmark.  

Thus, the rates discussed above act as indicators for the banking and financial system and give direction to the market.

With increase in interest rates, the fixed deposits become attractive for investing. However, one should be careful while assessing fixed income funds.

A sharp rise in interest rates would improve the returns from fixed income mutual funds having low duration such as Liquid Funds, Ultra Short Term and Short Term.  These short-term funds generate accrual income to the investors derived from investing in papers that offer high yields. But, the rising interest rates may cause the performance of GILT and Income Funds to weaken.

On the contrary, with falling interest rates, GILT and Income Funds may provide better returns as they have longer average maturity and higher coupon rates than the rest of the market. Thus, the fund manager can book capital gains with the increase in the bond price, an outcome of fall in rates. Learn more>>

Interest Rates Funds to consider^
Go Up Low duration such as Liquid Funds, Ultra Short Term and Short Term and FMPs
Fall Down GILT and Income Funds

Liquidity

Liquidity or simply, the amount of cash available in the system impacts the fixed income instruments.  If there is surplus cash in the system, the borrowers would easily find lenders to satisfy their credit requirements. Hence, there will be less fluctuation in the yield of debt securities. The overnight lending rates would particularly come down when liquidity is flush in the system. During such period, the return from liquid and liquid plus funds would be comparatively low and would reflect the call rates prevailing in the market, unless the fund manager invest in unrated papers or pass through certificates.

But the interest rates applicable on loans would increase if the available funding resources are limited. The borrowers thereby, would be willing to compensate the funding at higher rates for their immediate credit needs, resulting in higher bond yields in the debt market. Consequently, the liquid, liquid plus, short term and dynamic bond category funds would do well in times of liquidity squeeze.

Liquidity Funds to consider^
Shortage Liquid, liquid plus, short term and dynamic bond category funds
Excess GILT (stable G-sec Yield)

Inflation    

Presently, India deals with high inflation and a reasonably good growth.   The increase in food and fuel prices increases the input cost of business for the corporate sector as well as raises the household expenses for individuals.

Moreover, when investment return is lower, let’s say 7-8% and the prevailing inflation rate is at 10%, the value of accumulated savings for individuals gets reduced.

As a result, the returns generated from your fixed income funds may not compensate well for the inflation. Therefore, one can increase the allocation to equity asset class, as the long-term returns from equity funds can surpass inflation.

Chart 1: Inflation in India

(source: RBI)

Over a period of time, the sustained high prices may put pressure on the consumption driven economy like ours and hamper growth. Therefore, the central bank hikes the policy rates resulting in a tight interest rate regime as witnessed during the period 2010-2011 to control inflation. The high interest rates are expected to work as a lever to decelerate growth and in due course, tame inflation too. Fixed Maturity Plans are less sensitive to interest rate fluctuations. Thus, investors could consider FMPs and lock their money into high yielding papers.

Government Borrowing

The fiscal policy of the government affects the bond market. When the government borrows more to fund the infrastructure and development projects, there will be a larger supply of debt papers in the market. To facilitate borrowing, the government would be willing to give a better rate on the papers. Subsequently, the rate of borrowing in the economy goes up. Corporate and retail borrowers may face difficulty in availing credit, cutting down liquidity in the market. Ultimately, high interest rates would prevail in the market. The issuance of long-term debt papers by the government impacts the current yield on government securities.

With higher amount of government borrowing and less liquidity, the yield on long-term securities rises and bond price falls. During such periods, conservative investors should avoid putting their money in Medium Term, Dynamic Bond, Income Funds and GILT category funds.

When the macro-economic conditions get better, the RBI adopts a loose monetary policy and relaxes the key policy rates. Consequently, the high bond yields start to ease off from their peak points and aggressive investors can partly allocate money into Income and GILT funds. As the bond prices rise on account of improving fiscal situation, the debt fund manager can book trading profit on those long duration bonds.  For example, yield on a ten year G-sec trading at 8.25% plus levels would gradually fall down to a lower range resulting in higher bond price.  

Government Borrowing Funds to consider^
High Short duration funds, FMPs
Low Income and GILT funds

Conclusion

Generally, debt papers having a maturity of 180 days and above are traded in the market i.e., Marked-To-Market (MTM) component in the debt funds is sensitive to the factors discussed above. When the factors are favourable, the performance of the debt funds improves. However, the alpha return from a fund, the superior performance over benchmark and other funds in the same category, depends on the fund management style.

Therefore, before taking a call, you should browse through the fund factsheet to review the past performance, exit load, average maturity and YTM of the fund.

^Also, your risk profile and time horizom must be considered before deciding to invest!

Click here to view Recommended Funds


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