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Business News/ Money / Calculators/  Use bond funds to balance equity exposure
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Use bond funds to balance equity exposure

Tepid equity returns in 2015 may have upset your equity entry. Bond funds can help to offset the tilt

Jayachandran/MintPremium
Jayachandran/Mint

This is the biggest irony of equity investors. And mutual fund (MF) pundits say they have seen this trend repeat every time. When equity markets rise sharply (in the early part of a market rally), some investors recognize it and are usually the first to enter markets. Most retail investors follow, but only after sharp gains are over.

When equity markets rose by 30% in 2014, high net worth individuals’ folios grew by 69% (October 2013-December 2014). Retail folios fell by about 3%. During January-March 2015, equity-oriented funds added 1.18 million retail folios, when the market has been tepid (fall of 1% January 2015 to end-April).

While equity exposure is important, it’s best to check your asset allocation.

Using bond funds

If interest rates move down, bond funds’ net asset values go up, and vice versa. At present, interest rates are going down as inflation has reduced in the past year. The Reserve Bank of India reduced the repo rate (the rate at which it lends to banks) twice this year. The move also ensured that real rate of return (returns less inflation) remains positive. Predictably, bond funds have returned 13% in the past year.

But is it still a good time to invest in bond funds? Fund industry experts say that apart from the expectations of interest rate cuts, investors, especially those who have recently entered equity markets, should also look at bond funds. “Given that we have seen quite a sharp rally in equity markets, coming times may not see that kind of jump. We may see near-term volatility as companies are yet to show signs of improvement in earnings," says Vidya Bala head–MF research, Fundsindia.com.

A 27 April Mint report said that Indian companies may report their worst earnings in the January-March quarter in two years. This, stock market experts suggest, also shows that the run-up in the equity markets last year was mostly due to positive sentiment around the new government more than improvement in companies’ fundamentals. “We have run ahead of actual earnings growth; there is a paucity of clear signals and an abundance of noise," said Lalit Nambiar, fund manager and head of research, UTI Asset Management Co. Ltd. “Sharp movements reinforce the market trend as the fear of being ‘left out’ can force investors to join the party. Analysts have a tendency to be influenced by market price and anchor their earnings to price," he added.

The question is: after two rate cuts and 13% returns already, are bond funds worth it? Yes, because “yields haven’t come down commensurate to the rate cut. If you are investing for a period of 3-5 years, even a marginal rate hike—if monsoons are poor this year—shouldn’t bother," said Lakshmi Iyer, chief investment officer (debt) and head of products, Kotak Mahindra Asset Management Co. Ltd.

Others share the outlook. Ritesh Jain, chief investment officer, Tata Asset Management Co. Ltd, said, “If by 2017-18, the targeted rate of inflation, as intentioned, is 4%, there is a lot of steam for interest rates to come down, and investors would make money in bond funds."

Which bond funds?

There two types of long-term bond funds—duration and accrual. Duration funds aim to benefit from interest rate movements. They hold long-tenored (or duration) scrips that benefit when interest rates fall.

Accrual funds aim to earn higher yields from their scrips by investing in debt papers that carry a higher coupon. They aim to make money when credit ratings of their underlying companies improve. Maturities are typically lower than for duration funds. Corporate bond and credit opportunities funds are types of accrual funds. Many credit opportunities funds invest in slightly lower rated scrips to benefit from a higher underlying coupon the company could offer.

Bala feels it makes sense to invest in accrual funds at this point. “The rally in corporate bond yields (a fall in bond yields) isn’t over yet. The spread (difference in yields between a corporate paper and a government security of similar maturities) is yet to reduce," she said. So while government security prices have fallen, bond yields haven’t fallen as such. As on 30 April, 5-year government security index was at 7.8261% and the Bloomberg Fimmda Corporate Bond Curve AAA 5-year index was 8.3775%.

Also, when earnings growth finally takes off, improved profitability will lead to better credit ratings for companies. This, said Bala, will result in prices of corporate securities rising and a corresponding fall in their yields.

But there’s a twist. For debt funds, the period eligible to claim exemption from long-term capital gains tax is three years. So, if you have a horizon of 1-3 years, you need to hold on to your fund for three years to claim tax benefit. But yields don’t usually fall continuously for three years or more. So, what to do if yields suddenly go up during the three years? “It’s ideal to look for a bond fund that uses a mix of accrual and duration strategies. A duration strategy when interest rates are falling and an accrual strategy when rates becomes flat or rise," said Prateek Pant, executive director, products and services, RBS Private Banking India.

Your financial planner would be in a better position to determine a fund manager’s strategy that is ideal for your money.

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Published: 03 May 2015, 09:18 PM IST
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