5 Reasons why long-term debt funds might disappoint you now... - Outside View by PersonalFN

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5 Reasons why long-term debt funds might disappoint you now...
Dec 10, 2014

Most of the rally that we have seen in the Indian equity markets, over past 12-15 months has been a "hope rally". Now there is a performance pressure on Indian equities. If ground realities don't change much; equity markets may disappoint you sooner rather than later. Valuations are high so corporate profits have to fire up now. There are huge expectations from the NDA Government. Equity markets may not move further up, unless they expectations are met and reforms are fast-tracked. Moreover it may face a downward pressure.

What is true in case of equity markets is also true in case of Indian debt markets. It appears even debt market investors are expecting too much and may be too soon. Recently, yield on India's 10-Year sovereign bond slipped to a 16-month low. Usually when interest rates fall, yields fall along and bond prices rise. The impact of falling interest rates or yields is higher on bond prices with longer maturities as compared to those with shorter maturities. It might be possible that after seeing the recent rally in bond markets, even you are considering investing in long-term debt funds at this stage. If so, you should think twice.

Here's why?

This might come to you as a surprise that, despite of any change in the interest rates, bond yields are falling. To top it all, yield on India's 10-Year sovereign benchmark bond is now lower than the repo rate. In other words, markets believe that there are no significant opportunities in the long term thus leading to lower yields. The other connotation of this could be that markets believe lending for short term is more remunerative. In slightly technical terms, the yield curve now appears to be inverted and usually this happens when markets are expecting recession like times ahead. Nevertheless, current economic indicators definitely don't suggest that economy might slip into a rescission. Liquidity is not constrained either. Then what does it imply? The simple answer is overheating!

Why so?

India has been fighting the inflation bug for about 5 years now. However, it has achieved little success so far. All of a sudden, things have started looking better in the past 4-5 months. Inflation has finally started falling sharply and the overall investment climate looks optimistic. Therefore, there were great expectations that RBI may cut policy rates at its fifth bi-monthly monetary policy review. Contrary to the expectation, RBI held key rates unchanged. RBI stated that, there is enough room to doubt durability of the current trend of falling inflation. Moreover, various groups including industrial bodies, investors and consumers may have gone overboard with expectation of lower inflation going forward. For this reason, RBI believed, cutting policy rates would be premature for now.

Having said this, the central bank has tried to address doubts pertaining to future policy stance. RBI has also suggested that, once the monetary policy stance changes, policy actions thereafter would be consistent with the changed stance. In other words, if RBI starts cutting rates, it may adopt accommodative policy thereafter. As per RBI's statement, if macro economic factors appear encouraging, one might expect a rate cut even early next year. This has given markets a feeling that, policy rates might be down sooner and rather quickly.

On this backdrop, you must think holistically about changing macro-trends. If you invest in long-term debt funds now hoping to make quick gains, you might end up disappointing yourself. Here are the 5 reasons why it may so happen...

Reason #1: RBI might have given the best-case scenario when it said that policy rates could be lowered early next year. Don't forget it has attached a few conditions to doing so. They include:

    Downtrend in inflation should continue even in future
    Expectations of inflation must remain lower
    Developments on the fiscal front are positive.
All this may not fall in place within a month's time.

Reason #2: The RBI might be waiting to assess government actions in budget. Fiscal deficit until October has run over 90% and that puts pressure on the government finances. Higher fiscal deficit may discourage RBI from lowering rates.

Reason #3: The primary factor in falling inflation has been a drop in international crude oil prices. If, for any reason, prices start going up internationally, then the fall in inflation may prove to be short-lived.

Reason #4: RBI is skeptical about rabi crop being able to compensate for the decline in kharip crop. It also perceives falling prices of fruits and vegetables as seasonal phenomena that might reverse within months. On the other hand, it believes, inflation in protein rich foods might stay for long. All this suggests inflation expectation in true sense has not lowered as yet, a big negative for rates.

Reason #5: Last, but not the least, all possible positives could have been already factored in by markets, leaving little scope for further rallies in bond prices.

PersonalFN believes, you should never try to speculate on a particular event. Moreover, your investment decisions should not be based on outcomes of those events. Now, speculating about the policy stance of the RBI in coming months could be a futile exercise. There is a possibility that RBI may hold up rates for long simply for not being convinced with the macro-economic developments. This might even reverse investor sentiments if they have to wait for more time.

Therefore, as an investor, you would be better off if you concentrate on your financial goals. While investing in debt funds, always consider your time horizon first before zeroing on any fund. Mind you, debt funds are not risk free. If you have a time horizon of more than 3 years, you might invest in long-term debt funds, provided you have a high-risk appetite. Taking a cautious approach, you can even stagger your investments over next few months. Also make sure that your exposure to long-term debt funds does not exceed 20%-25% of the entire debt portfolio.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.


The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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