Debt mutual funds to offer higher returns in next 1-2 years: How investors can benefit Debt mutual funds returns in the coming years will be impacted due to lesser government borrowings as well as inclusion of Indian government securities in the global index
The government in the interim budget 2024 announced its intention to reduce its borrowings in the upcoming fiscal year, 2024-25. According to the Interim Budget 2024, "The gross and net market borrowings through dated securities during 2024-25 are estimated at Rs 14.13 and 11.75 lakh crore, respectively. Both will be less than that in 2023-24."The amount of money that the government borrows from capital markets impacts the yield and correspondingly the pricing of the bonds trading in the market. This has a major influence on the interest rate that private institutions offer to borrow afresh from debt markets. Capital markets have limited capacity to absorb debt instruments in any given financial year.
Government typically remains the single largest borrower in the debt market and its quantum of borrowing sets the direction of the yield. Higher the supply of the bonds, higher will be the yield and lower the bond price the market is willing to pay. If government borrowing is lower, bond yield (interest rate offered on the bonds) typically remains subdued and makes the market more favourable for private players to issue bonds at lower yields which reduces their total cost of borrowing. In a falling interest rate regime where interest rates are likely to fall further, these bond prices will follow old existing bonds in secondary market and will witness rising prices with each rise in overall interest rate.
Remember, government securities are considered risk-free investments. Private institutions normally have to offer a higher interest rate than government securities to compensate for the higher risk (as compared to government bonds) associated with their bonds. Hence, if the government reduces its borrowings from debt capital markets, the interest rate that a private company has to pay will be comparatively lower than what it has to pay if the government borrows more.
Impact on debt mutual fund returns
Lower supply of government bonds will have a positive impact on debt mutual funds' returns. There is an inverse relationship between price and yield of a bond. Lower supply of government bonds will mean lower interest rates and higher prices on bonds in secondary market.
Harish Reddy, Co-founder, Stable Money, says, "The central government has pegged the FY25 gross borrowings at Rs 14.13 trillion, i.e. 8% lower than the previous financial year. This will help in pushing down the benchmark bond yields on account of reduced government bond supply in the market. Therefore, investors who have already invested in debt mutual funds will see higher returns over the next few months."
Abhishek Bisen, Senior EVP & Fund Manager, Kotak Mahindra AMC, says, "This is likely to be beneficial for bonds as demand growing normally and supply coming off may lead to price gains in existing bonds, effectively enhancing the returns of the fixed-income assets which are subject to mark to market. Normally, higher the duration, higher the gain."
Addition of Indian government bonds in global index
Apart from lower government borrowings, the upcoming fiscal year will see the inclusion of Indian government bonds in two global indices: JP Morgan Government Bond Index-Emerging Markets (GBI-EM) from June 2024 and Bloomberg Emerging Market Local Currency Government Indices from January 31, 2025.
Jigar Patel, Member of the Association of Registered Investment Advisers, says, "Once the Indian government bonds get included in the JP Morgan index and Bloomberg index, it means more international flows to the bonds. As a result, the demand for the bonds will go up and yield on the government bonds will further reduce. This will affect the investors investing in long-term G-sec mutual funds. With the current 10-year G-sec yield at 7%, this news may not have been already priced in, and there is an opportunity for both existing and prospective investors to make money."
Which debt mutual fund category will benefit the most?
According to Sebi categorisation, there are 16 categories of debt mutual funds such as dynamic bond fund, corporate bond fund and gilt fund. Reddy says, "When the bond yields fall, prices rise in proportion to the time to maturity and, therefore, long-term bond funds benefit the most."
Patel says: "Mutual funds with higher duration will benefit more. So long-term debt funds and dynamic debt funds that have increased duration in the portfolio are expected to benefit more from the reducing interest rates. Also, long duration G-sec funds will also benefit from decreasing G-sec yield."
Bisen says, "So far, duration category of funds - i.e., gilts, bonds and dynamic bond funds - have been the key beneficiaries; however, as higher the duration higher the gain, hence the returns. So short- to medium-term funds have also benefited, albeit less than higher-duration funds. We expect a similar trend to continue."
Here is an example to understand the impact of maturity profile of the bonds. Suppose two existing bonds with similar risk profile having interest rate of 6% are trading in the secondary market. The bond A having maturity 7 years away is trading at Rs 110 and bond B, which is 2 years away from maturity, is trading at Rs 103. Now due to changes in macro economic factors the interest rate falls, the yield on new bonds issued in primary market falls to 4.5%. Due to this, the prices of bonds in secondary market will also change and move up. Hence, the prices of bonds A and B will rise in the secondary market. However, price of bond A will rise more than bond B due to higher time till maturity.
Debt MF investors will benefit
Debt mutual fund investors will see higher returns from their existing investments. But what about investors planning to invest in debt mutual funds in the upcoming financial year?
Reddy says, "Existing debt mutual fund investors will benefit the most as they will get capital gain benefit, as the price of bond increases with a fall in bond yields. Investors who are planning to invest in the next financial year will not be benefitted much as bond yields' movement has already begun, not leaving much on the table for fresh investments."
Bisen says, "Existing investors shall benefit more. The later you invest in debt mutual funds, the lower the returns new or prospective investors will get. However, as interest rates are expected to cool off from the current level, new investors are also likely to get some benefits." This is because the Reserve Bank of India (RBI) has kept the interest rate unchanged since April 2023. Hence, there might be a waiting period till debt mutual fund investors start seeing higher returns from their investments despite the new developments mentioned above.
Bisen says, "Good returns is a subjective term. And as there are many factors which impact yields, it is difficult to quantify the same. However, as we are going into an easy rate cycle, fixed-income products are likely to give superior risk-adjusted returns for the next 12-18 months."
Patel says, "There is no fixed time frame. However, debt mutual fund investors would benefit if they held the investments until the interest rate bottoms out. It could take 1-2 years or more."
This story originally appeared on: India Times - Author:Faqs of Insurances
