Jan 11, 2018 10:55 AM IST | Source:

3 lessons you should learn from the roller coaster ride of bond funds

The biggest behavioural flaw for most investors worldwide is to chase what is hot.

Nikhil Walavalkar @nikhilmw

Stellar returns posted by bond funds in CY2016 attracted many investors. However, most of these investors are now wondering if they have made a wrong choice as the past year has fetched lower single digit returns. The volatility in bond funds’ returns offers some important lessons to investors. Here they are:

Never base your investment decisions only on the past returns

The biggest behavioural flaw for most investors worldwide is to chase what is hot. CY2016 ended with income fund offering average returns of 11.9% that made many investors jump for investing in these schemes. However, CY2017 turned out to be a bad year, in which these funds offered 4.96% returns. Same is the case with dynamic bond funds — another popular type of bond funds. These schemes returned 3.55% in CY2017 as compared to 13.41% returns registered in CY2016.

The only thing that changed the fortunes of all these schemes is the upward movement of interest rates in the Indian economy. The benchmark 10-year yield saw more than 110 basis point surge in CY2017 from its low in CY2016. When the interest rates go up, bond prices fall and the NAV of schemes holding these bonds follow them. Most of these schemes were holding long term bonds to benefit from falling interest rates. However, as the tide turned the NAVs took the heat.

“Most investors forget that in market-linked returns offering, investments returns are not linear. Never ever base your investments only on the returns in immediate past,” says Vijai Mantri, co-promoter and chief mentor at BuckFast Financial Advisory Services. Dynamics of the asset classes change and so do the financial markets. Returns tend to oscillate from time to time. If you look at what has happened in the immediate past and invest accordingly, you may suffer due to sub-optimal returns.

Expected returns and past returns in debt market is a tricky business

Though most novice bond investors expect the trend to continue till eternity, experts think otherwise. “Expected returns from bond funds are inversely related with the past returns,” says Feroze Azeez, Deputy CEO of Anand Rathi Wealth Management Services. If you see much higher returns than the long-term average returns in a given calendar year, rest assured that the next year may offer much lower returns than the average. The other way round also holds good, he adds.

Interest rates tend to oscillate. When the interest rates move down, the bonds see capital appreciation. If you sell at that point of time, you will get the capital appreciation. If you have to reinvest the money so received in the bonds again, you will have to settle for a lower rate of interest. If you do not sell when the bond prices are high, then you lose your opportunity to book capital gains, but you continue to earn interest at the predetermined rate which is higher than the going rate.

Let’s also look at the other side. If the interest rates go up, you will see marked to market loss on your bond investments. If you sell you will book your losses. But you will get to invest at a higher rate of interest. If you do not sell, you do not lose. As the bond nears maturity the bond prices comes back to the face value. You get your capital back along with all the interest earned over the tenure of the bond.

Things revert to mean

After reading the above paragraph, this becomes obvious. But not many investors pay adequate heed to it. The asset allocation should also take into account this phenomenon that the returns revert to mean. No asset class can offer above average returns till eternity. As they say, what has gone up will come down and what has gone down will go up. Asset classes must be seen in the context of both the recent returns and the long term average returns.

So far so good. But does that help you. The moot question remains – what will happen to all these investments in these schemes?

The experts advise staying put. “Hold on to your investments in these schemes. Do not sell in panic. These schemes will perform much better than the previous year as interest rates may not harden as much as expected,” says Vijai Mantri. There is a fair chance that you will end up making money over CY2018. But a word of caution here.

“The upward movement in bond yields are not random. Rising crude oil prices can push up inflation and further push up interest rates. If USA keep on increasing interest rates, it will have rub-off effect on Indian interest rates. Upcoming elections may make government to loosen strings of its purse. This may result in missing the fiscal deficit target and force government to borrow more which will push up interest rates,” points out an analyst with a life insurance company, who wished not to be quoted. If the interest rates continue their journey upward then these schemes will offer sub-optimal returns, he adds.

So what should you do if you have some money to invest in fixed income space and you do not want to lose your sleep on this interest rate volatility?

“Look at corporate bond opportunities funds investing in bonds that typically mature in two to three years. These schemes tend to invest in bonds rated less than AAA and offer superior returns as compared to the bond funds investing in AAA bonds, given the higher credit risk,” says Feroze Azeez. Opt only for those schemes that have a solid track record.

Does the story really end here? Not really.

Let’s see the first lesson: Never base your investment decisions on the past returns

Small Cap Equity Funds have delivered 55.89% returns and topped the performance tables. Are you one of those queuing up to invest in these schemes?
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