Debt fund opportunities – the category that’s at a low

The headlines now are devoted to sliding equity markets and stock opportunities to ‘buy the dip’. But that’s not the only window of opportunity to make the most of a correction. With the hike in repo rates earlier this month and a clear path now for higher rates, debt markets too offer scope for timely investments. 

We have, accordingly, issued a series of recommendations to latch on to higher yields. We’re adding to this list in today’s fund recommendation to capture debt fund opportunities. No, don’t groan at yet another recommendation possibly confusing you! Each of our calls have been for specific purposes:

1. Target maturity passive debt funds, which are useful for those who aren’t looking for income-generating options and have a fixed timeframe; their tax efficiency coupled with the ability to lock into yields made them good options.
2. Gilt recommendations, in early May and in mid-May, useful for those needing income-generating options. Locking into high yields for the long term offers a far higher degree of predictability and comfort.
3. SDL recommendations, whose suitability for investors is similar to gilts mentioned in the point above. You can check our past and future gilt and SDL recommendations here. This is available for Growth subscribers only. 
4. We’d also begun recommending adding on floating-rate funds and other very short-maturity fund to catch the interest rate upcycle as yields here will see a quicker assimilation of the rising rate scenario.

Now, your needs may not match the fixed-term or income-generating recommendations we have made so far. You may have, of course, added on some short-maturity funds in your debt portfolio. But if you have the risk appetite and at least 5-7 years in holding period, the rise in rates has triggered a correction and offers a good window of opportunity in a particular set of debt funds.

That opportunity is in gilt constant maturity funds. Constant maturity funds are gilt funds that maintain a steady maturity of around 10 years. Owing to the rise in interest rates, this debt fund segment has seen returns correct – and therefore, investing in these funds now is similar to investing at lows. This will help improve returns when rate cycles eventually turn back lower. Here’s why, who can invest in these funds, and which fund to go for.

Return correction and debt fund opportunities

In a scenario of rising rates, yields of existing bonds rise in reaction to match the higher new rates. That happens by way of a drop in bond prices. But bond markets do not wait for an actual hike in rates, but move in anticipation of the rate cycle. As we have been explaining over the past several months,  gilt yields across timeframes have already been ticking up. 

The upward movement in rates comes after a prolonged period of flat or falling interest rates. The repo rate has dropped from 6.5% to 5.15% between 2018 and 2019, before the Reserve Bank slashed rates to all-time lows of 4% due to Covid. The repo was between 6% and 6.5% for the two years prior to that. The 10-year gilt yield has generally trended lower for the past 4 years.

That meant gilt funds hammered out hefty returns up until 2021 as a falling rate cycle sends bond prices up. For example, 1-year returns of constant maturity funds and gilt funds were as high as 15% in 2019. These returns helped keep overall longer-term returns strong; 3-year returns for constant maturity funds were about 11% even for nearly the whole of 2021. 

But with bond markets factoring in a rate hike for a while now, yields have shot up and prices have dropped. The 10-year gilt yield, which was about 5.8-5.9% in January 2021, moved up to about 6.1-6.2% by mid-2021 and then to 6.5% by the end of 2021. The Reserve Bank’s out-of-turn sharp rate hike in May triggered a fierce reaction with the 10-year gilt shooting up to 7.2%. 

With the rise in yields and consequent fall in bond prices, fund NAVs have taken a hit. Longer-term maturities generally see a strong reaction to higher rates, compared to short-term maturities. This is because they have to readjust the ‘income’ for a longer residual period till maturity. The prices have to fall to deliver higher yields till maturity. Returns for constant maturity funds have, accordingly, been sliding from mid-2021. The chart below shows the movement of average 1-year returns and 3 month for the category. As you can see, funds have now slipped into the loss-making zone in the 1-year period.

So, what does this mean? Very simply, the high returns in long-term gilt funds that came about earlier due to falling rates have reversed – that is, a correction has taken place in this debt fund segment. Investing in these funds now would be similar to catching the lows, averaging costs lower. When the rate cycle eventually moves up, the rally in bond prices will push returns back higher and the lower costs will add a further uptick.

Constant maturity funds

Here is how we think you can capture this debt market opportunity – invest in constant maturity gilt funds, either using SIPs for the next 6-8 months or making a few lump sum investments spread out over a 6-month period. However, note the following points in this strategy:

• One, picking up constant maturity funds now will involve a higher risk appetite. Returns will be low or even in losses in the short-term period. As long as interest rates remain high, fund returns will pale in comparison to funds following an accrual strategy. Accrual funds will see portfolio yields and therefore returns pick up as they adjust to higher rates – unlike constant maturity funds, they are less subject to bond price fluctuations, especially with shorter-term funds. If you’re looking for steady and higher returns especially in this current scenario, avoid constant maturity funds and stick to shorter-term accrual funds.
• Two, for constant maturity funds to deliver, you will need to hold it for at least 5 years, although returns may start kicking in once rates fall . Returns in these funds come more from a rally in bond prices than earning interest accrual on the gilt instruments. Therefore, you need the time to allow the rate cycle to reverse from rising/flat back to falling. For interest accrual too, the long maturity also requires you to hold for a longer timeframe.
• Three, you are not ‘locking in’ at current yields – which is where this constant maturity call differs from the other debt recommendations we have given so far. Our recommendation is based on the correction these funds have seen, to buy on the low in order to improve returns once bond prices rally. Note that constant maturity funds do not hold only the 10-year gilt. They mix gilts of different maturities to maintain an average 10-year portfolio maturity. Next, these funds will book appreciation in bond prices once the rate cycle shifts, which can offer returns above the interest accrual alone. Finally, because these are open-ended funds, portfolio yields will shift based on the gilts the fund holds over time. For instance, the category’s average yields for April come in at about 7.09%, up from the 6.6% in January 2022.
• Four, constant maturity funds are not meant for setting up an income stream. They are best used in long-term portfolios alone. If you already have short-term or medium-term accrual funds, adding on a constant maturity fund will diversify the manner in which you play the debt market opportunity. 

You may already hold constant maturity funds in your portfolio; if you already have SIPs in these, let them run as usual or start SIPs now for the next 6 months. This will help you average your costs down as you may have been investing through their high-return period. If you do not hold these funds already, now is a good time to add them through SIPs as you will be entering at a low.

Why now, why not hold off for a further rise in yields, and why constant maturity funds? 

As far as timing goes, we’d prefer to begin investing now as, for one, while the Reserve Bank has officially raised rates only now, markets have already been pricing in higher rates. Two, inflation has been driven more by supply-side constraints than a surge in demand. The Reserve Bank will have to balance hiking rates along with stimulating economic growth; sharply higher rates can hurt growth. So, it might resort to sharp hikes over a short period – more like a high dose medicine for a short while. The government has also taken its own steps to tame inflation through fiscal measures. 

Globally, too, the risk of inflation couples with the risk of recession. Therefore, central banks will have to play their rate hikes carefully. Further yield rallies from here can thus be more unpredictable. Our 10-year gilt yield has generally peaked out at about 7.8-8%. Investing through SIPs or in multiple lumpsum investments over the next few months addresses the possibility of further yield rally and not missing out even if these do not come by.

In terms of an opportunity in a correction, constant maturity funds are the best-placed, compared to other accrual categories, even if they are long-term debt funds. Gilts see the most reaction to rate changes. Other accrual debt funds such as corporate bonds or medium duration, even where they are relatively longer-term by nature, make their returns primarily from earning interest accrual. 

Dynamic bond funds have several layers of risk – fund maturity, credit quality, strategy of shifting between accrual and duration based on the rate cycle. Long-duration funds are the only ones that come close to constant maturity gilt funds, as they have to maintain a 7-year maturity profile. But when you’re already taking on duration risk by going for long term maturities, we do not think it’s necessary to add an element of credit risk which may be present in long-duration funds and absent in constant maturity funds.

Constant maturity gilt funds are more predictable than other gilt funds (with any duration). Constant maturity funds maintain an average maturity of 10 years, using a mix of different gilt maturities. Therefore, there is some level of predictability in terms of what can hurt returns, when and how returns can pick up, level of volatility and risk. 

That’s much harder with regular gilt funds. There is no certainty over the maturity the fund goes for – this is a call the manager takes. If the fund manager intends to cut risk or protect downsides, for example, the fund could shift to short-term gilts. To indicate how much calls vary with gilt funds, April average maturities range anywhere between less than 2 years to 5 years to 8 years. Some funds have taken very tactical calls of going even beyond 10-year maturities. Therefore, it’s hard to peg whether investing in these offer investing at current lows.

Fund recommendation

There are only 4 funds in the constant maturity category. Among these, our recommendation is SBI Magnum Constant Maturity, which is also part of the Debt – Long Term bucket in Prime Funds. The fund has consistently done better than other category funds. It has shown the ability to both deliver returns while keeping volatility and risk contained. The other funds in the category either deliver well on the upside but fall more or are less consistent in performance. The SBI fund, consequently, manages better risk-adjusted returns.