Banking & PSU bond funds: Past perfect, but time to temper return expectations

Why Banking and PSU debt funds?

Given all the negativity around the non-banking finance companies (NBFCs) space, liquidity crunch and news of firms defaulting on interest and principal repayments, safety was paramount on investors’ minds.

The idea was to invest in a portfolio that comprises bonds issued by banks and public sector undertakings (PSUs). It is highly unlikely that investors would witness a default in this space. These funds are mandated to invest a minimum of 80 per cent of their corpus in bonds issued by banks and PSUs. Given the low credit-risk associated with these bonds, investors with modest risk appetites took to these schemes in droves. The low expense ratios compared to credit risk funds make the returns attractive.

Says Devang Shah, deputy head-fixed income, Axis Mutual Fund, “A cut in policy rates and infusion of liquidity in the banking system by the Reserve Bank of India ensured that the bond yields on three-year AAA rated papers fall to approximately 6.5 per cent from 8.5 per cent a year ago. Most of the banking and PSU bond schemes were invested in two or three-year bonds and hence investors have seen good returns in these schemes.” The past one year’s returns are a combination of the interest earned from bonds held and capital appreciation. When interest rates fall, bond prices rise, and vice versa.

What went wrong with UTI BPSU?

The scheme had 9 per cent of its corpus invested in Jorhat Shillong Expressway (JSEL) – a special purpose vehicle of IL&FS. After the downgrade in the credit rating, the fund house provided for the same by reducing the net asset value of the scheme.

“The investment was done bases on the ring-fenced structure and cash-flows coming from National Highway Authority of India – a AAA rated PSU. However, subsequent moratorium on repayments imposed by National Company Law Appellant Tribunal on the IL&FS group also hit the group companies including JSEL and stopped the repayments of loans. That has in turn hit the scheme. Clarity will emerge after final decision is taken by authorities concerned,” said Sudhir Agrawal, fund manager – fixed income, UTI AMC.

Though experts point to the lack of clarity on the interpretation of the law, the fact is investors are sitting on losses.

This incident underlines the need for checking the portfolios of schemes before investing. The fund manager is allowed to invest up to 20 per cent of the scheme’s corpus in bonds not issued by banks and PSUs. Fund managers may invest in low-rated papers to boost the returns of the portfolio and so risks may creep in.

Should you invest?

“If you are planning to invest in these schemes just because they delivered very good returns in the recent past, then it is a bad idea,” says Feroze Azeez, deputy CEO, Anand Rathi Private Wealth Management. You should instead focus on the yield to maturity of the scheme when you are planning to invest in a bond fund, he says. If we go by average yield of 6.8 per cent and average net expense of 60 basis points, then the net yield works out to 6.2 per cent. This is in line with one and three-year fixed deposits offered by nationalised banks – not attractive, if we keep aside the tax treatment of the returns.

Though these schemes invest mostly in short to medium-term bonds maturing in two to three years, if the interest rates move up, these funds may be hit if yields move too quickly.

“These schemes are not attractive for fresh investments. Existing investors can remain invested in these schemes. But they must moderate their return expectations,” says Rupesh Bhansali, head – mutual funds, GEPL Capital. If you have remained invested for three years in these schemes and are comfortable with a bit more risk, you can also consider redeeming the same and look for alternatives. Bhansali prefers to invest in short-term bond funds. If you have a time-frame of less than one year, then stick to liquid funds and ultra-short term bond funds, he adds.