K. VENKATASUBRAMANIAN | Business Line | November 30,2013|

See-sawing interest rates have led to fluctuating fortunes for bond funds. Here are the funds that have been the most consistent. Park your one-year money in them.

Barely three months ago, bond funds, particularly those that invest in long-term government securities, were the flavour of the market. Many of them sported double-digit returns and were attracting retail investors in droves.

But Fed taper fears and the RBI’s sledgehammer measures in July to hike the cost of money have taken the fizz out of this party. One-year returns on bond funds may today look better than that on equity funds, but they have taken a hard knock from three months ago.

Long-term gilt funds have been the worst hit by the unexpected spike in rates, with their returns at 5 per cent for one year. Short-term debt funds now average 6.5-7.5 per cent for one year. Short-term gilt funds, benefiting from the spike in short- term interest rates and tight liquidity, are topping the category at 7.5 per cent.

So what should investors in bond funds do now? Funds, especially with a short maturity profile of one-two years, remain a good investment option, with interest rates still at high levels and liquidity remaining relatively tight.

Short term gilt funds

Short-term gilt funds, of which there are about 20, have navigated the recent see-sawing interest rates well.

The sharp spike in short-term borrowing rates after RBI measures in July created good opportunities for these funds to buy into high-yielding government bonds.

The subsequent decline in rates has also allowed these funds to gain from some price appreciation too (when interest rates fall, bond prices gain and gilts are among the securities to respond the most to interest rate changes.) Short-term gilt funds have generated averaged returns of 7.5 per cent over the past one year.

The benchmark for short-term gilt funds, I-Sec Si-Bex, has delivered returns of 7.6 per cent. But a few funds have delivered 2-3 percentage points more, with a couple of schemes delivering double-digit returns as well.

Sundaram Gilt, Religare Invesco Gilt Short Duration and IDFC GSF Short Term delivered 12-19 per cent returns over the past one year. Birla Sun Life Gilt Plus Liquid, DSPBR Treasury and UTI G-Sec managed 9 per cent or more. Funds that fared well invested mainly in 91-day treasury bills and sovereign debt with two-three months maturity profile. However, the above returns have a one-off component that may not be replicated over the next one-two years. The current yield to maturity is 8.5-9 per cent for many of these funds. In the last five years, the category has generated a 6.4 per cent return compounded annually.

Where to invest: Though returns from short-term gilt funds are likely to moderate as interest rates subside from recent highs, they will remain attractive for investors seeking safety over a one to two-year horizon.

Religare Invesco Gilt Short Term, Birla Sun Life Gilt Plus Liquid, IDFC GSF Short Term and SBI Magnum Gilt Short Term are funds that investors may consider. They have outperformed their benchmark 75-80 of the time over the past three years on a rolling basis and have a five-year track record in the category.

Long -Term Gilt Funds

Long-term gilt funds (43 funds) delivered just a 5.1 per cent average return over the past one year and 6.8 per cent over the past three years. Even over a five-year timeframe, these funds have delivered a modest 5.8 per cent annually.

From a low of 7 per cent earlier this year, yields on the 10-year government bond have spiked to nearly 9 per cent now. The sudden spike in yields over the past few months has caused erosion to their NAVs.

This is the category that suffered the most in the debt markets carnage as medium and long-term gilts hold more long-term bonds. The ICICI Composite Gilt Index delivered 6.2 per cent over the past one year, while the I-Sec Li-Bex managed just 4.7 per cent. Both indices delivered about 7.8 per cent returns over a three-year period.

The best funds in the category have delivered more than 9 per cent over the past three years. Long-term gilt funds across the board have reduced their average maturity profile from over 13 years in some cases to about 10-12 years, while medium term schemes had a profile of 4-8 years. Investments in long-term gilt funds carry high interest rate risk and it is best to take exposure to them at the peak of an interest rate cycle.

Based on the criteria of long-term track record and consistency in returns, the following funds may be suitable for investors: IDFC GSF Investment, SBI Magnum Gilt Long-term and L&T Gilt Investment have a maturity profile of over 10 years and have delivered quite well over the past three years.

Dynamic bond funds

Dynamic bond funds have the flexibility to shift between government and corporate bonds based on where opportunities lie. They invest in corporate bonds, certificates of deposit, commercial paper and debentures, in addition to gilt investments.

In the last one year, the category delivered 6.2 per cent returns on an average, while on a three-year basis the returns are at 7.9 per cent. In the last five years, the dynamic bond funds as a category has delivered an average annual return of 7.4 per cent. Initially caught unawares by the RBI’s move to hike rates, these funds have quickly adjusted to the changes by reducing the average maturity profile across schemes. The medium-term schemes reduced their average tenure by about two years to 1.5-4 years, while the long-term funds have cut their holding periods to 8-10 years.

These funds have used the opportunity provided by the spike in short-term rates to buy commercial paper and certificates of deposit of quality companies offering double-digit coupon rates. As a result, the yield to maturity of most dynamic bond funds is in the 9-11 per cent range. Good options in this space are Birla Sun Life Medium Term, Templeton India Corporate Bond Opportunities and HDFC Medium Term Opportunities which have average maturity profile of 1.5-4 years and yield to maturity of 9.5-11 per cent.

These funds have a consistent track record and have beaten standard benchmarks across timeframes. Some of these funds invest in bonds, commercial paper and debentures of HDFC, PFC, Tata Motors, India Bulls Housing Finance, Tata Sky, M&M Financial Services and Aditya Birla Finance, among others. They take slightly higher risks by investing in A or AA rated instruments as well, but are compensated for it with higher yields.

There are also other dynamic bond funds that have a higher average maturity profile. Investors need to have a slightly longer term horizon of four-five years for such investments to give adequate returns.

Birla Sun Life Dynamic Bond, Templeton India Income Opportunities, Canara Robeco Dynamic Bond and IDFC Dynamic Bond may be quality investment avenues for investors based on their sustained performance record. Investors can choose one or two funds from the above categories as a part of their debt investments, so that the total number of debt schemes invested in does not go beyond three or four.

Source: http://goo.gl/bV6AmF